Tax Strategist: Independent Contractor vs. Employee Status: A New Focus of the IRS

If you are a small-business owner, whether you hire people as independent contractors or as employees will affect 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 hire.

The obvious advantage to treating an individual as an independent contractor is to avoid 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 IRS 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 should 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:

1. Consistently have treated the workers in the past as nonemployees;
2. Have filed all required Forms 1099 for the workers for the previous three years, and
3. 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 contact your Tax Consultant.

How to Classify Workers

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: 
   1. 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. 
   2. 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.
   3. The type of relationship factor relates to how the workers and the business owner perceive their relationship.
2. 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.
3. 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.
4. Employers who misclassify workers as independent contractors can have substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.
5. Workers can avoid higher tax bills and lost benefits if they know their proper status.
6. 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 your Tax Consultant. Your Tax Consultant can help determine whether the person you are paying should be classified as an employee or an independent contractor.

Disclosures:

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.