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Misclassifying Employees as Independent Contractors

IRS Tax Relief: Small businesses often run up against IRS auditors by calling their workers independent contractors instead of employees. The interests of the business owners and the IRS are diametrically opposed: Tire IRS wants to collect employment taxes for as many workers as possible, and the business owner wants to avoid employment taxes. This tends to result in payroll tax problems often requiring the business owner to seek tax relief.

Indeed, a small business can save a bundle by not classifying workers as employees. According to the U.S. Chamber of Commerce, it costs a business 20% to 40% more per worker to treat them as employees.

How the IRS Finds Out
If your business is audited for any reason, the IRS looks at payments made to independent contractors.

The Wall Street Journal reported that in one six-year period, the IRS performed more than 11,000 audits of companies using independent contractors. The results: 483,000 reclassifications of independent contractors to employee status and $751 million in back taxes and penalties. Tax relief anyone!

Also, special IRS teams search for misclassified workers under the ETE (employment tax examination) program. Typically, these ETE audits focus on industries where they suspect abuses. Recent targets include temporary employment agencies, nursing registries, and building contractors. Enterprises can also be selected for filing many Form 1099s for independent contractors.

The IRS is very selective in its enforcement of work classification rules. It picks on small businesses, while major corporations often flout the worker classification rules. Some of the largest employers frequently hire independent contractors. These Fortune 500 giants furnish offices, require regular work hours, and treat these so-called independent contractors like their regular employees—except they do not pay employment taxes or give the workers any benefits.

CAUTION State employment tax agencies can also penalize you. If a worker who was misclassified as an independent contractor is laid off and makes a claim for unemployment benefits, it triggers a state agency inquiry. If the state reclassifies a worker as an employee, the business owner will be in for all kinds of payroll tax problems plus penalties. The state may also turn the employer in to the IRS or vice versa.

Penalties for Misclassifying Workers
The IRS can order offenders to pay all employment taxes that should have been paid, plus a tax penalty ranging from 12% to 35% of the tax bill.

EXAMPLE: Ray, who wholesales American-made bathing suits, laces stiff competition from cheap imports. To survive, he must keep prices low by cutting overhead to the bone. Ray decides to call his secretary, warehouse person, delivery person, and two inside salespersons independent contractors. Here’s what he stands to save:

  • Administrative work—filing quarterly tax-reporting forms, withholding employees’ pay, and making federal tax deposits.
  • Social Security and Medicare taxes. (With independent contractors the employer does not pay 7.65% of their wages as Social Security and Medicare taxes.)
  • Federal and state unemployment tax costs.
  • Nontax expenses, like workers’ compensation insurance, and employee benefits, such as sick leave and vacation pay.

The problem is that Ray’s workers are likely to be employees, not ICs.

IRS Classification Settlement Program
The IRS offers an olive branch or form of tax relief to small business owners found misclassifying employees. It’s called the Classification Settlement Program (CSP). This is a relatively inexpensive way to come clean by making a CSP deal.

To qualify for the CSP, a business owner must:

  • Have an open case with the IRS, either in an audit or in appeals
  • Specifically request a CSP deal, and
  • Be in compliance with § 530 of the 1978 Revenue Act (known as the safe harbor rule). That means an employer must have:
    • Filed all tax returns, including Form 1099s showing independent contractor payments
    • Treated all similarly situated workers as independent contractors
    • Had a reasonable basis for misclassification, such as reliance on court decisions, IRS rulings, or written IRS advice; a past audit that resulted in no employment tax liability for workers in positions substantially similar to the workers

Qualifying employers will be offered one of three settlement deals:

  • Past misclassifications won’t be assessed taxes.
  • The most recent year of taxes for misclassifications must be paid and the IRS will forget about prior years.
  • 25% of the latest audit year deficiency must be paid.

In addition, employers must agree to classify the workers as employees in the future. The IRS will monitor your business for five years to make sure you don’t fall back into your old ways requiring additional tax relief.

Which one of the three deals you get depends on the judgment of the auditor or appeals officer—and your ability to convince them you acted reasonably. Excuses that may work: reliance on the advice of an attorney or accountant; industry practice, even if not widespread; or your misinterpretation of the 20 factors used by the IRS to determine if a worker is an independent contractor.

EXAMPLE: The IRS audits Ray and reclassifies his secretary, Faye, as an employee. Faye was paid $20,000 per year for the past three years. Ray’s audit bill, with interest and penalties, could be as much as $30,000 if the auditor decides that Ray intentionally disregarded the law. If, however, the IRS auditor concludes Ray made an innocent mistake, the tax bill would be about $15,000. Either way, it is a lot of money.

Avoiding Trouble With the IRS
To avoid having the IRS reclassify your independent contractors as employees, they should:

  • be paid by the job, not by the hour
  • work off your premises in most cases
  • hold business licenses and workers’ compensation insurance coverage (if applicable), and
  • have a written agreement spelling out the terms of the relationship and acknowledging they are independent contractors.

If an IRS auditor attempts to reclassify your worker as an employee, a written agreement with the contractor may win the day. It won’t help if the worker is obviously an employee, but it can be persuasive in borderline situations.

In the agreement, the worker should acknowledge a contractor status and should spell out his or her responsibilities. (Pay attention to the IRS list of factors above.) Include a clause stating that all payments to the contractor will be reported to the IRS on Form 1099 and a Form W-2 will not be used.

Tax Tip
Develop your own form IC agreement. If you plan to regularly hire independent contractors, develop form contracts and require all contractors to sign one before they start working for you this will help you stay on the good side of the IRS  and help keeping you from needing tax relief.

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