IRS Wants Its $7 Billion From Independent Contractor Misclassifications

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Battered by bad press about aggressive practices, the Restructuring and Reform Act of 1998 ushered in an era of a kinder, gentler IRS. Twelve years and an extra $7 trillion in debt and the gloves are off. The President's 2011 budget provides for a hundred new IRS agents to ramp up their enforcement efforts. Mislabeled contractors are among their priorities. 6,000 companies have already been targeted as potential violators.

The Department of Labor estimates that 30% of companies misclassify employees as contractors. The General Accounting Office estimates the cost of the problem at $7 billion a year in underpayment of social security taxes, unemployment insurance, and income taxes. What's more, it’s estimated that almost a third of misclassified contractors underreport their income, a double whammy to the Treasury Department's coffers. And it's not just the IRS that has contract labor in its sights. Most states have also ramped up their enforcement action. Some, such as California, actually have stricter employee definitions than Uncle Sam.

For business owners, hiring contractors saves 20-30% per worker. It allows them to replace the fixed cost of a salaried employee, with a pay-as-you-go labor solution. And, it gives them access to a much broader talent pool — one that provides access to that just-right resource for the job at hand. Not surprisingly, the contractor model is particularly appealing in a down economy.

Unfortunately, what seems like a great way to save money may be costly in the end. If it's determined that your contractors are misclassified, you'll owe back taxes (what you should have paid if they had been treated as employees), plus hefty penalties. And have no doubt: Your state will want in on the action as well.

So let's review the rules about contractors vs. employees. The key lies in the degree of control you exert and independence they have. Excerpted from the IRS web site, here are the key behavioral, financial, and relationship issues that determine whether a person should be considered an employee.

Behavioral

Does the company control or have the right to control the worker?

Contractors generally provide their own tools/equipment, can hire others to assist them, purchase their own supplies and services wherever they like, choose who is to perform the job, and determine the order or sequence of the work.

Contractors are generally free to work when, where, and however they choose.

Whether a company actually controls how a person works is less important than whether or not they have the right to do so. In a contractor relationship, they should not have the right.

Contractors do not typically require training. The more training, and the more frequently it's given, the more likely a worker is to be deemed an employee.

Financial

The more a business controls the financial aspects of a worker's job, the more it points to an employee relationship.

Contractors typically have a significant investment in the equipment they use to perform work (though the term significant is not defined).

Contractors typically have costs that are not reimbursed by the company. These are their own costs of doing business.

The ability to make a profit or lose money is a good indication that someone is a contractor.

Contractors seek out business through advertising and other means.

Contractors are more likely to be paid a flat fee for their work, though it's recognized that in some professions, hourly billing is standard practice.

Relationship

Having a contract that says a worker is a contractor and therefore responsible for his or her own taxes does not make it so. How the parties work together is what matters.

Contractors should not qualify for insurance, pension plans, paid time off, etc.

Contractors are usually retained for a defined period of time or until the completion of a project. If you give someone the expectation that the relationship will continue indefinitely, it will look a lot like an employee relationship.

Contractors do not typically provide services that involve key aspects of a business. The IRS gives the example of a law firm that hires an attorney. Since the firm will likely present the attorney’s work as its own and have the right to control or direct that work, that person would be considered an employee.

Note that no one factor stands alone in determining the nature of the worker/company relationship. What's more, what's relevant in one situation may not be in another.

Having a well documented reason for how you arrived at the decision to treat workers as contractors — for example, an IRS prior ruling, standard industry practice, or even a prior audit that didn't question your approach — may help if you're challenged, but it's not a get-out-of-jail-free card.

If all this hasn’t give you enough to worry about, consider that while the IRS or state tax board may not have you in their sights, others might. A disgruntled contractor, an "on-the-contract" injury, or even an unhappy employee can trigger an audit.

An ex-IRS agent turned accountant was fond of saying that some of his clients liked to eat well, others liked to sleep well. Which do you like?