June 2011

By: Nancy E. Joerg, Esq.

Background of increased IRS auditing: In February 2010, the IRS began intensive audits of 6,000 randomly selected companies. One of the key areas of focus was and is worker classification – determining whether businesses are misclassifying workers as independent contractors to save on taxes and legal risks.

The IRS has pumped up its auditing efforts because it believes that the very challenging economy has encouraged more businesses to misclassify members of their workforce as independent contractors.

Narrowing the tax gap is the key motivation behind IRS proposals to crack down on misclassification of employees as independent contractors. Businesses must withhold income taxes, withhold and pay social security and Medicare and pay unemployment taxes on wages paid to employees, not to independent contractors. Employees are more likely to withhold and submit taxes than independent contractors (who are more likely to avoid tax responsibilities).

Why would employers want to classify their workers as independent contractors? Companies, especially small ones, increasingly use independent contractors because they provide greater flexibility with the size of the workforce and are usually cheaper – as much as 30% can be saved by avoiding payroll taxes, unemployment insurance, worker’s compensation coverage, and benefits normally provided to regular employees.

In tough economic times, using independent contractors makes economic sense because it is usually easier to terminate them per the contract if the company needs fewer workers.

Consequences of misclassified independent contractors: The issue of proper classification of workers as employees or independent contractors can have severe financial consequences to the business that misclassifies its workers. Not only is the company subject to retroactive tax withholding, but also penalties and interest if the classification is incorrect. In many cases, the liability springing from an employment tax audit could end the life of the business.

Employment taxes are “trust fund taxes”: This means that officers and owners of the company have personal liability for these taxes and cannot discharge them in bankruptcy if the business cannot pay. Thus, the IRS takes no prisoners. If employment taxes are misappropriated in any way and there is a misclassification, the owner is generally personally liable.

How do you properly classify a worker as an independent contractor? The IRS uses a 20-factor test to determine whether a worker is an independent contractor or an employee. Basically, the more control a company has over a worker, the greater the likelihood that the worker would be classified by the IRS as an employee.

The 20-factor test is not an objective test. Surprisingly, there is no special number of factors that a taxpayer company must pass in order to prove independent contractor status. Rather, the company must simply “do as well as it can” under the 20 factors (and then hope that the IRS agent is convinced that the workers at issue are independent contractors and not employees). Some factors are more important than others, depending upon the industry and the type of independent contractor at issue.

Section 530 relief in an IRS audit: For businesses that have historically classified workers as independent contractors, a special provision (Section 530 of the Revenue Act of 1978) provides a “safe harbor” exception from the usual 20-factor test. Under this safe harbor, the IRS may not reclassify workers as employees – even prospectively or for newly hired workers.

In certain circumstances, Section 530 can relieve businesses of employment tax liabilities resulting from worker misclassification, but the business must meet specific requirements under the law.

Section 530 has three requirements, all of which must be passed , in order to receive relief:

1. The company must consistently use the kind of workers at issue as independent contractors (this means, for example, that the company has used the workers as independent contractors, and not as employees, through the years), AND

2. The company has faithfully issued IRS Forms 1099 where required, AND

3. The company has a reasonable basis for having classified the workers as independent contractors in the first place. (Note: There are many ways to prove this.)

Steps businesses should take to avoid worker classification problems: With increased audit scrutiny from both the state and federal levels, employers should audit their independent contractor relationships to ensure that they will withstand inspection by the IRS. This is an area in which a little prevention can go a long way:

• Review all independent contractor agreements to strengthen independent contractor status;
• Follow the IRS “common law” 20-factor test carefully;
• Obtain a Form W-9 from the independent contractor, pay by check to the independent contractor’s business name, and issue a Form 1099-MISC to the independent contractor’s business name;
• Fill out an IRS SS-8 Form for each classification of worker to do a self evaluation of independent contractor status;
• If an individual is really an employee, do not try to classify the person as an independent contractor;
• Ensure and preserve Section 530 relief and eligibility;
• Watch for an IRS SS-8 Form request, payroll audit questions, or other signs of any IRS worker classification audit;
• Do not “flip flop” and change the independent contractor status in an inconsistent fashion. Maintain consistent treatment of independent contractor status to the greatest extent possible.

In the event of an audit: If your company is selected for audit, do the following: 1) pick a clear “chain of command” for responding to audit notices and other IRS communications; 2) immediately consult with an attorney who knows independent contractor classification issues including Section 530; 3) request additional time to respond to information document requests.

Please contact Wessels Sherman Senior Attorney and Shareholder Nancy Joerg at 630-377-1554, or najoerg@wesselssherman.com, to work on lowering your risk in using independent contractors.