Independent Contractor or Employee? IRS Audits are heating up!

14 March 2013 / Uncategorized / Comments Off on Independent Contractor or Employee? IRS Audits are heating up!

So you think because you don't withhold taxes and pay people with a 1099, that you are safe from all those payroll taxes?  Think Again!

Internal Revenue Service auditors show up every day with little to no warning at businesses all over the country seeking to verify that outside contractors aren't, in fact, full-time employees.  These types of audits are part of a government crackdown on employers who misclassify workers as independent contractors to avoid paying payroll taxes, and other employment-related expenses.

The legal distinction between full-time staff and independent contractors can be very confusing for many employers.  Even if everyone has been classified correctly, the audits are "nerve wracking" because tax law doesn't make it easy to distinguish between full-time staff and independent contractors doing full-time work.  The legal distinction can be confusing even for an employer with his decades of experience in the labor market.

The appeal of using outside workers is growing as many small businesses struggle to stay lean. Some employers also are turning to contractors to avoid hitting the 50-employee threshold that would require them to pay for employees' health insurance, starting next year, under the federal health-care law, or pay a penalty.

State studies have shown that local businesses misclassify anywhere from 10% to more than 60% of their workers as independent contractors. Many business owners blame the complex tax code, which doesn't offer black-and-white standards for telling the difference. The distinction is primarily based on the employer's degree of control over a worker, but there are a series of other factors. But such factors are open to interpretation and past court cases on the issue have had differing outcomes, providing little guidance.

In the past three years, the IRS, working with the Labor Department and officials in more than a dozen states, set a goal of investigating 6,000 employers to ensure their workers are properly classified. Since September 2011, the government has collected $9.5 million in back wages for more than 11,400 workers who were misclassified as independent contractors by their employers as per the statistics provided by the Labor Department.

The crackdown is aimed in part at boosting tax revenue. Employers don't pay or withhold income taxes, Social Security, Medicare or unemployment taxes for independent contractors, as they do for employees. The U.S. Treasury estimates that forcing employers to properly classify their workers—while tightening so-called "safe harbor" rules that provide them with leeway in determining who is and isn't an employee—would yield $8.71 billion in added tax revenue over the next decade.

Despite the threat of a payroll audit, more small employers are finding that independent contractors are essential to remaining competitive. The number of small firms that rely on outside contractors, for everything from technology services and public relations to marketing and sales, has grown sharply over the past five years.

Using independent workers gives employers flexibility to hire only when there is work to be done, and leaves them with fewer tax obligations—and thus less paperwork—than do regular full-time workers. Using contractors also can cut benefits costs: they typically aren't eligible for such benefits as health insurance and paid maternity leave.

A Michigan State University study estimates that contractors can save employers as much as 40% on labor costs. Indeed, some business owners say the IRS audits could stifle their ability to grow as demand picks up.  A payroll audit is a major disruption for a small business.   In addition to the legal expenses, the downtime is just not worth taking the risk.

Rather than risk an audit, and perhaps costly penalties many small-businesses are rushing to convert any long-term contract workers into permanent staff.  In January, the IRS extended an amnesty program designed to encourage employers to voluntarily reclassify contractors as employees by waiving some penalties. Under the program, employers pay as little as 1% of the wages paid to their reclassified workers the previous year, rather than the full amount they owe in back taxes. So far over 1,000 employers have signed on since the program was launched in 2011.

In recent years, Congress has proposed various bills to clarify the definition of independent contractors, including as recently as December, though none of them have passed. Without a clear definition of who counts as an independent contractor, many employers don't know whether they are complying with tax rules until they get audited.

The IRS provides a wealth of information on the topic, and a review of Form SS-8 can assist employers with many of the questions they should be asking when making this critical decision.  The link to the IRS is:

At Widget, we are here to help.  If you would like assistance in this area, please feel free to give us a call!

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