Independent Contractor versus Employee Status – A New Focus of the IRS

• Posted on November 22, 2011
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If you are a small business owner, whether you hire people as independent contractors or as employees will impact the amount of taxes you withhold from their paychecks, as well as how much and what types of taxes you pay. Furthermore, it will affect how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.

The obvious advantage to treating an individual as an independent contractor is avoiding the added expense of payroll taxes and employee benefits. Unfortunately, the decision is not optional, and employers must be careful when making the decision, lest they set themselves up for a payroll audit and back taxes, penalties, and interest.

Independent contractors are becoming a new focus of the IRS, and audits in this area are expected to rise sharply in the next few months. The IRS and the Department of Labor have agreed to share information and collaborate on the issue of employees who have been misclassified as independent contractors. An IRS study on the subject found that 15% of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $2.7 billion in inflation-adjusted 2006 dollars. The IRS already has in place a nationwide questionable employment tax practices (QETP) program. One of its goals is to increase voluntary compliance with employment tax rules and regulations.

The Internal Revenue Service has launched a new program that will enable many employers to resolve past worker classification issues and to achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers. This new program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.

To be eligible, an applicant must:

• Consistently have treated the workers in the past as nonemployees,
  
  
• Have filed all required Forms 1099 for the workers for the previous three years, and
  
  
• Not currently be under audit by the IRS, the Department of Labor, or a state agency concerning the classification of these workers.

Interested employers can apply for the Voluntary Classification Settlement Program at least 60 days before they want to begin treating the workers as employees. Employers accepted into the program will pay an amount effectively equaling just over 1% of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations rather than the usual three years that generally applies to payroll taxes. If your firm would like to apply for this program, please give this office a call.

Here are some things every business owner should know about hiring people as independent contractors versus hiring them as employees.

1. Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral control, financial control, and type of relationship.
   
   
2. Behavioral control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training, or other means.
   
   
3. Financial control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job.
   
   
4. The type of relationship factor relates to how the workers and the business owner perceive their relationship.
   
   
5. If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
   
   
6. If you can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your workers are probably independent contractors.
   
   
7. Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.
   
   
8. Workers can avoid higher tax bills and lost benefits if they know their proper status.
   
   
9. Employers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. A worker may also file Form SS-8 requesting an IRS determination. IRS does not issue determinations for proposed or hypothetical situations.

If you need more information about the critical determination of a worker’s status as an independent contractor or employee, please call this office.