Increased Audits for Employers of Independent Contractors

By Greenstein Rogoff Olsen & Co. LLP
Posted 4/21/11

For over 30 years the IRS has been limited by the Federal Revenue Act of 1978 from creating a more detailed definition of the difference between an independent contractor and an employee. Under the Obama administration 2011 Revenue proposals, this will all change. With the proposed changes, the IRS would get a chance to hold the reins of power on determining who is and who isn’t an employee or an independent contractor. In turn, this will lead to an increase in the number of audits for those employing independent contractors.

Why is the IRS increasing audits of employers of independent contractors?

According to the Obama administration, there is enough Independent Contractor misclassification that it substantially affects the Tax Gap. It is believed that by giving the IRS the power to further define what classifies a person as an independent contractor, and then increasing enforcement of that definition, it would increase tax revenues by more than $7 billion over 10 years. Under the proposed “Fair Playing Field of 2010” Act, the Obama administration would set aside $37 Million dollars to ramp up enforcement of the new and existing guidelines on what constitutes an independent contractor. Some states have already organized task forces designed to increase enforcement efforts.

What does this mean for you?

If you are an employer of independent contractors you will be under closer scrutiny by the IRS. With $7 Billion of lost tax revenue on the line, the IRS will be looking under every rock and pebble for those who may be misclassifying their workers. The IRS doesn’t care if you accidently misclassified, there will still be penalties.

If you are an independent contractor and the IRS believes that you should have been classified as an employee, they will asses penalties to your employer. However, you are still held responsible to have paid in full all the taxes associated with being an independent contractor.

If you are an employer that classifies its workers as employees, the change may still affect you. As your competitors, who may have been classifying their workers as independent contractors, are forced to reclassify their workers as employees, their costs will increase substantially. This will level the playing field as you compete in the same market. This is why many employers are supporting federal and state initiatives to enforce classification of workers as employees.

If you are an employee, you have a better chance of remaining classified as an employee. In this economy, and as tough as the job market has been, workers have been more willing to be misclassified as independent contractors then otherwise would be the case. As an independent contractor that should be classified as an employee, you stand to lose a substantial amount of worker benefits; Goodbye dental, health, and vision insurance.

Why do people misclassify their workers?

There are many reasons why employers would want to classify their workers as independent contractors. When a worker is classified as an independent contractor, the employer does not have to pay social security, Medicare, and unemployment insurance taxes for those workers. The employer is also off the hook from having to withhold income taxes on behalf of their workers, as well as offering the workers any kind of employee benefit plan. This can provide significant savings to an employer that classifies a worker as an independent contractor as opposed to an employee.

What are the penalties for misclassifying a worker?

If you are forced to reclassify a worker from an IRS audit you lose the chance to deduct the taxes associated with employee wages. Also, you can’t recover the tax owed from the worker; it’s coming out of your pockets. To give you some hard numbers, let’s look at a couple different situations from the perspective of an employer who misclassified their workers as independent contractors, when they should have been classified as employees.

All employers who misclassify a worker as an independent contractor are subject to pay, for each worker misclassified,

1. 100% of the taxes you were supposed to withhold (as the employer) for FICA
2. 100% of the FUTA taxes that should have been paid for the worker, applied only up to $7,000 of the worker’s wages. This is reduced to 0.08% of the first $7,000 if the state unemployment tax was paid on time.

Those penalties are just the beginning. You are also subject to pay additional amounts depending on your particular situation (described below).

Scenario A
You made an honest mistake, and you have filed correctly all your tax returns (including all the appropriate 1099’s). You are then subject to pay for each worker misclassified,

1. 1.5% of the wages paid to the worker as a penalty
2. 20% of the amount that the worker was supposed to withhold for FICA

Scenario B
You made an honest mistake, but incorrectly or falsely filed your tax returns. You are then subject to pay for each worker misclassified,

1. 3% of the wages paid to the worker as a penalty
2. 40% of the amount that the worker was supposed to withhold for FICA

Scenario C
You intentionally misclassified your worker as an independent contractor. Then you call a lawyer, and are subject to pay for each worker misclassified,

1. 20% of the wages paid to the worker as a penalty
2. 100% of the amount that the worker was supposed to withhold for FICA

Please note, these scenarios only represent the federal penalties. Some states are currently working to enact criminal penalties and fines. For example, Colorado has a first time offense fine of up to $5,000 per worker, and up to $25,000 per worker if it happens again. In short, misclassifying can be very expensive.

How do you prevent misclassification?

That is the golden question. To quote from the IRS website, “There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor”(http://www.irs.gov/businesses/small/article/0,,id=99921,00.html)

Thankfully, there are some guiding principles that many employers will find useful. Basically, the more control an employer has over a worker the greater the likelihood that they would be classified as an employee. The three areas that provide evidence of the degree of control an employer has over a worker are behavioral, financial, and the type of relationship. Questions to ask yourself include the following:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?”¹

The more you answer “yes” to the preceding questions the greater the likelihood that the worker should be classified as an employee and not as an independent contractor, however nothing can fully substitute the competent advice of a tax professional. It’s good to be educated on the issues, better to follow the guidelines, and best to know that you are following the guidelines correctly. This is where a tax professional can help.

What can you do if you may have misclassified a worker?

If you feel that you have misclassified your workers in the past, you should know that the IRS will lower its penalties for those who reclassify their workers prior to IRS contact. The lowering of penalties will only be allowed if all the required 1099 forms had also been filed (prior to IRS contact). Remember, there is no substitute for a competent professional opinion. Seeking the advice of a tax professional will help you to ensure that you are in full compliance with the current IRS regulations for classifying workers. It is best to know if you are compliant before you get audited; however if you wait and see, and find yourself under an audit, it is still tremendously useful to get the help of a CPA.

We here at Greenstein, Rogoff, Olsen and Co. have been the trusted advisor to the highly successful since 1964. We specialize in consulting services and accounting services to closely-held businesses and high net-worth individuals. If you would like competent Tax advice regarding the classification of Independent Contractors, or on any other tax issue.