The IRS and Dept. of Labor have an existing audit program to determine if business owners are properly classifying workers as independent contractors. In these audits, the burden of proof is upon the employer to prove that the worker is an independent contractor. While many business owners are aware of the IRS and DOL audits, many are unaware that states also have unemployment compensation (UC) audits.
The determination of whether a worker is an employee or an independent contractor is NOT made by the employer (or the hired worker). It is determined by the facts. How an employer interprets those facts may not be the same as the IRS’s or state’s interpretation . . . so proceed with caution and proper tax planning.
What does a typical state auditor examine to determine if independent contractors were misclassified? The auditor will review payroll W-2s and Form 1099-MISC filings (required for payments of $600 or more made to a provider of services). The auditor wants to become familiar with these persons. The auditor will also review the check register to identify frequent payments made by the business to determine if other persons should have received a W-2 and also to ensure that all payments made to employees were included on a W-2. The auditor is likely to ask for an explanation of any payment made to an individual. The auditor will likely want to discuss in detail the services provided by the independent contractors, look at invoices by the independent contractors, review independent contractor agreements, and attempt to make a determination as to whether the independent contractor works exclusively for the business (perhaps indicative of employee status) or has other clients (typical of independent contractors). The auditor will also desire to speak with the business owner which most tax advisors would strongly recommend that the owner not do.
How does an employer determine whether a worker is an employee or an independent contractor? First, consult with your tax advisor. The IRS also provides guidelines on its website which can be found at http://www.irs.gov/pub/irs-pdf/p15a.pdf. The IRS guidelines discuss many of the 20 common law factors that the courts have used to determine if an individual is an employee or contractor. The IRS also gives examples of specific determining factors for certain industries. You can also review Form SS-8 (which can be completed by either the employer or employee) to see the factors that are reviewed to determine employee vs. contractor status (http://www.irs.gov/pub/irs-pdf/fss8.pdf).
The key element that is measured is “control”. When an employer has control over the daily activities and duties of an individual, that is prima facie evidence that an employer/employee relationship exists.
What are the employer risks when an individual is misclassified as a contractor? A few examples include:
- If the company has a qualified retirement plan, the employer could be found to have a top-heavy plan that discriminates against employees, may have a disqualification of the plan, business and individual income taxes may be due (with interest and penalties), and could be subject to numerous ERISA excise tax assessments.
- The individual is entitled to company-paid benefits, such as vacation, sick days, health care, etc.
- The employer share of payroll taxes (FICA, Medicare, FUTA & SUTA) would be due.
- The IRS could assess the employer for the employee share of the payroll taxes plus 20% of the gross pay as payment for the individual’s personal income taxes if the IRS was concerned that the income was not reported by the individual (e.g., where the business owner failed to file a Form 1099).
- Late payment and interest assessments for remitting the required payroll tax withholdings late. Since these employment tax audits can be conducted years later, the interest and penalty assessments can be significant.
While many audits are random, others are generated because of actions taken by the person classified as an independent contractor. Examples as to why the individual may take such action include:
- The employer notifies the contractor that his/her services are no longer needed. The individual has nothing to lose by filing for unemployment benefits since the work relationship has been terminated.
- The individual is hurt on the job, is uninsured, and files for workers compensation benefits.
- The individual wants the company-paid benefits given to employees.
- The individual is disgruntled and notifies the PA or federal DOL because he does not feel comfortable confronting the employer or simply wants payback.
- The individual files Form 8919, which is part of Form 1040, to contest the payment of the employer share of the FICA & Medicare taxes.
- The individual does not realize that he is responsible for his own payroll taxes (when classified as a contractor) until his Form 1040 is prepared and he sees the amount of taxes owed to the IRS, and then wishes to be classified as an employee.
- The employer files Form SS-8 and triggers an employment tax audit.
If an independent contractor is used, it is best to secure a properly completed Form W-9 before payment is remitted to the contractor. Also, don’t use words like “supervise”, “hire”, “benefits”, and “wages”, but rather use words like “manage”, “engage”, and “service fees”. Include in the vendor file bids, contracts, public advertisements, business cards and stationery, licenses, permits, and invoices related to your contractors.
Be sure to read the Disclaimer page on our Blog. This Blog is for educational purposes only and should not be considered the rendering of tax advice.
