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Business Owners, IRS and Increased Audits of Independent Contractors

  • Posted by Michael Beauchemin on Mon, Nov 12, 2012 @ 01:40 PM

    As a means of trying to survive and grow in today’s economy, businesses are reevaluating all aspects of their business processes and business model. This includes more closely monitoring and managing its workforce. 

    Several factors including; the uncertainty of the economy, the impending tax increases, and the additional requirements of employers to comply with the Patient Protection and Affordable Care Act, have caused businesses to rethink how they manage and utilize their labor force. 

    Many are turning to Independent Contractors to complete tasks that previously were performed in-house with their own employees. 

    While utilization of Independent Contractors can be a successful strategy, care should be taken to make sure that you are correctly classifying the person as an Independent Contractor. 

    In two previous posts, It’s All About Tax Compliance for Businesses and Corporations and Independent Contractors and the IRS, A New Start for Your Business we highlight how the IRS is taking an aggressive stance with businesses that misclassify workers as Independent Contractors rather than employees. Businesses may be fined and responsible for paying payroll back-taxes if the IRS determines that a worker was misclassified. 

    In addition to the increased scrutiny by the IRS, states are doing the same.  For example in North Carolina in October, officials from the state Labor Department met with the Unemployment Tax Division to discuss how they could work together to increase compliance. 

    Last year in NC, 2,637 businesses were audited by the Division of Employment Security and 40% of the audited businesses were found to be in non-compliance with the law.  An additional 3,000 businesses were found to be in non-compliance by tips and grievances filed by workers and problems when workers applied for unemployment benefits.  

    As government agencies look for opportunities to increase revenue to help offset budget deficits, expect these investigations, audits and plans for departments to work collaboratively together to become common place.        

    The IRS and state agencies use several different factors to determine whether a worker is an employee or can be considered an Independent Contractors.  All of these factors relate back to control over the worker.  If an agency determines that an employer exerts enough control such that an employer-employee relationship exists, they can reclassify that worker from an Independent Contractor to an employee. At which time, you can be looking at hefty back-taxes and severe penalties.

    Here are just three items they may look at:

    1. Profit or Loss.  Can the worker make a profit or suffer a loss as a result of the work, aside from the money earned from the project? (This includes real economic risk and not just the risk of not getting paid.)
    2. Investment.  Does the worker have an investment in the equipment and facilities used to do the work?  (The greater the investment, the more likely an Independent Contractor relationship exists.)
    3. Works for More Than One Firm.  Does the person work for more than one company at a time?  (This tends to indicate independent contractor status, but isn’t conclusive since employee can also work for more than one employer.)

    These are just a few of the factors the IRS or other state agencies may look at.  If there is any doubt as to whether a worker can be reclassified from an independent contractor, you may want to seek clarification before the person is engaged to do the work, or you  may want to consider outsourcing to a company.  For example, if you hire an independent contractor to do your payroll and bookkeeping, they come to your office, use your computer and take direction from you then they may be considered an employee whereas if you outsource to another company to provide this service you can avoid the issue altogether. 

    To assist you with HR related issues such as hiring and terminating employees, I9 compliance, personnel related issues, etc. we are offering a discounted HR trial membership.