IRS Cracking Down on Employee vs. Contractor Classification

By Michael D. Koppel, CPA, MSA, PFS, CITP
Gray, Gray & Gray, LLP
March 2013

If your company hires independent contractors in any capacity, be prepared to prove their independence, or you may face fines, penalties and back taxes. Ouch!

The Internal Revenue Service (IRS) and Department of Labor have announced plans to aggressively crack down on companies who – intentionally or accidentally – misclassify workers as independent contractors, thus avoiding paying payroll taxes and benefits, including health insurance and retirement plans. Workers may want to be classified as independent contractors in order to take deductions against their income.  Even if both the business and worker agree, the government may reclassify the worker.

A recent tax court case summarized the criteria that the IRS considers in determining if a worker is an employee or an independent contractor:

1. The degree of control exercised by the principal over the details of the work;
2. Which party invests in the facilities used by the worker;
3. The opportunity of the worker for profit or loss;
4. Whether the principal can discharge the worker;
5. Whether the work is part of the principal’s regular business;
6. The permanency of the relationship; and
7. The relationship the parties believed they were creating.

Unfortunately, the court has not indicated which criterion is the most important or how many it takes for determination of classification.

Tax law does provide certainty in some situations.  Under a special safe harbor rule (sec. 530 of the Revenue Act of 1978) a worker can be treated as an independent contractor if a business:

• Consistently treated the worker and similarly situated workers as independent contractors;
• Complied with the Form 1099 reporting requirements with respect to the compensation paid the workers for the tax years at issue; and
• Had a reasonable basis for treating the workers as independent contractors.

While these three criteria appear straightforward, in practice they can be quite complex, especially having a reasonable basis for treatment of the worker.

This attempt to identify misclassification of employees is not new. The IRS has been reviewing questionable employee vs. independent contractor relationships for many years. But as the pressure to generate additional tax revenues has increased so has the scrutiny and diligence of the IRS. The importance of an employee classification is even more important with the impending health care requirements.

If you think you may have misclassified employees and are worried about paying financial penalties, the IRS has a program that could significantly reduce the amount you may owe.  The Voluntary Classification Settlement Program (VCSP) is designed to significantly reduce the amount a business would have to pay the IRS.  To qualify for the VCSP a business must meet the following criteria:

• Consistently have treated the workers in the past as nonemployees,
• Have filed all required Forms 1099 for the workers for the previous three years
• Not currently be under audit by the IRS
• Not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers

If a taxpayer is accepted into the program they will only have to pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. Additionally, the taxpayer will avoid interest and penalties. However, you need to hurry – the VCSP is scheduled to expire June 30, 2013.

There is another important factor to consider. If the IRS does reclassify workers as employees and determines that withholding and payroll taxes should have been paid by the employer and the business cannot make the payment, the IRS can make “responsible individuals” in the business pay the taxes.

It is very important that you take the time to examine all relationships you have with independent contractors. Consult with your accountant or attorney to determine if you need to reclassify any contractors to avoid the stiff penalties that could result if they are actually deemed to be an employee.