As part of the National Research Project, examiners for the Internal Revenue Service will begin 6,000 planned audits of businesses to take place over the next 3 years.  The audits will focus on employment taxes, specifically backup withholding for 1099s, fringe benefits, employee-independent contractor status, and executive/officer compensation.  The purpose of this article is to discuss the most common employment tax issues included in the audit, understanding the difference between a W-2 employee and a 1099 independent contractor.

Being in the payroll industry, we get asked this questions frequently: Do I have to withhold taxes if I have an agreement with my employees that they will pay their own taxes?  The answer is yes.  The distinction between employee and independent contractor is not determined by an agreement between the employer and the individual.  It is determined by the IRS and many business owners/officers (especially new businesses) simply do not understand this.

It is also common among larger employers to misclassify independent contractors based on a particular job function that is not directly related to the day-to-day operations, such as a janitorial crew.

So the question becomes, how do you determine if the individual is an employee?

To answer this question, first lets look at the Common Law test, then we will review the factors used by the IRS in determining employee status and what to do if you think you have misclassified workers.

Common Law Test

The basis of the common law test is pretty simple:  Does the employer have the right to control what work will be done and how that work will be done?  If the answer is yes, then the worker is an employee subject to payroll tax withholding.  If the employer has the right to control the result and not the method in which the result is achieved, then the worker generally qualifies as an independent contractor.

The table below is used for determining whether a worker is an employee under the Common Law test:

Although this seems easy to understand on the surface, lets take a closer look at the factors that the IRS uses to determine worker classification.   

Factors Used By IRS

Currently the IRS does not have any official rules governing worker status, however IRS auditors look at the following three categories: Behavioral Control, Financial Control, and the Relationship of the Parties.

Behavioral Control - Does the employer have the right to direct or control how the worker performs the specific task?  More specifically, ask yourself the questions below and if you answer yes then the worker is most likely an employee.

• Are instructions given about when, where, or how to work?
• Are directions provided as to which tools or equipment to use?
• Are worker's told whom to hire or assist with work?
• Is management approval required before taking certain actions?
• Do workers undergo periodic or ongoing training?

Financial Control - The most significant evidence of financial control is whether or not the worker has an opportunity to either make a profit or suffer a loss.  If so, the worker is most likely an independent contractor.  The following four aspects can be used to determine financial control.

Investment - for a worker to be treated as an independent contractor, the worker must have an investment in facilities and tools used in the course of performing services.

Expenses - independent contractors will normally incur expenses at their own cost that impact the worker's opportunity for profit.  The focus here is on unreimbursed expenses, specifically fixed or ongoing costs that are incurred regardless of whether or not work is performed.  Examples are:

•         Rent
•         Utilities
•         Training
•         Advertising
•         Insurance
•         Wages to others
•         Licenses

Marketable Services - independent contractors will offer their services to the available market and will normally maintain a visible location and advertise their business.  Lack of these activities may point to the worker be classified as an employee.

Method of Payment - in general independent contractors are paid a flat fee or commission for a performing a task.  Employees however are generally paid by the hour, day, or pay period indicating a guaranteed return for their work.

Relationship Of The Parties - How do the worker and business view each other in terms of control.

Written Contracts - a written agreement describing the worker as an independent contractor and indentifying the payment terms, reimbursable expenses, and work performance methods may be used to classify the worker as an independent contractor, but in itself is not sufficient evidence.

Employee Benefits - benefits such as sick or vacation time and health insurance are normally only provided to employees and would weigh heavily in determining that a worker is an employee.

Termination - the ability to immediately terminate the worker would indicate employee status.  However this should not be confused with a business' ability to refuse payment to an independent contractor for unsatisfactory work.

Continuing Relationship - independent contractors are usually hired for a specific period of time or task to be performed.  Employees are usually hired for an indefinite period.

Regular Business Activity - if a worker's services are a primary aspect of the regular business activity of the organization, then the worker is most likely subject to a certain amount of control by the business and is, therefore, considered an employee.

What To Do Now

If you feel you may have workers misclassified, the best course of action would be to reclassify the workers, back to the beginning of the current year.   If you have doubts about a worker's status, the IRS offers assistance to employers and workers by filing out form SS-8 and sending it to IRS.  You can access form SS-8 here:   http://www.irs.gov/pub/irs-pdf/fss8.pdf

In the event the IRS reclassifies an individual to an employee, the employer will most likely be required to pay employment tax that was not withheld on payments during the misclassification.  IRS code allows for employment tax payments of 1.5% of the employee's federal income tax liability and 20% of the amount that should have been withheld for the employee's FICA taxes.  In addition, if the employer failed to file 1099s during the period of misclassification, the employer's liability doubles to 3% and 40% respectively.  Employers that are required to pay this liability may not recover any tax from the employee or deduct these amounts from future compensation.

Any intentional disregard to withhold taxes will most likely result in more stringent penalties.  

In the event you are unsure as to how to classify a worker, it is best to err on the side of caution and classify the worker as an employee.  It is always less painful to receive a tax refund than it is to pay a tax penalty. 

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The information on this Site is provided for informational purposes only. It does not, and is not intended to, provide any financial, insurance, legal, accounting, tax or other professional advice, and should not be relied upon by you in that regard. It is not a substitute for professional advice from a competent, independent advisor in your jurisdiction.