IRS Gets Class Conscious: Switching to
Independent Contractors Draws Scrutiny
Shifting from full-time employees to independent contractors is a recessionary cost-cutting
measure some businesses implemented. But for those who have misclassified their workforce,
the glare of the IRS spotlight may soon be upon them. Over the next three years, the Internal
Revenue Service is auditing 6,000 randomly selected businesses to determine whether they
have workers who've been classified as contractors when they should be treated as
employees. When appropriately done, classifying a worker as a contractor allows a business to
escape unemployment, Social Security and Medicare taxes and overtime pay. Additional taxes,
penalties and interest result from worker misclassification.
"The Department of Labor is also cracking down," says Annette Idalski, chair of the labor
and employment litigation group at Chamberlain, Hrdlicka, White, Williams & Martin in
Atlanta. "We've seen a 50 percent increase in our DOL activity. Several employers have been hit
with DOL audits ... and are facing devastating damages calculations on back pay alone.
"Oftentimes, these findings are incorrect and employers should be prepared to set the record
straight."
A tip-off to the feds comes when a worker files for unemployment benefits identifying a business
as a W-2 former employer. "The IRS' standard information request is directed at companies who
have provided a worker with both a Form 1099 and Form W-2," says Tom Cryan Jr., a member
at Miller & Chevalier in Washington, D.C., who has defended companies in IRS audits.
"Businesses should have only issued Form 1099s, not W-2s, to contractors."
More tormenting for unsuspecting business owners is that a voluntary correction may actually be
waving a red flag attracting an investigation.
"Right or wrong, worker misclassification is viewed by the IRS as a loss of revenue," Cryan
says. "Correcting a mistake may signal an ongoing misclassification. It's easy for the IRS to
discover changes in worker classification through the audit process."
The workforce should be structured with the Labor and IRS worker classification audits in mind.
"It ought to be raising an eyebrow if the individual reports to your office every day and performs
functions for your business, yet no one else. That's the situation that the IRS is looking for with
these audits," Cryan says.
Idalski agrees: "Companies should be wary of laying off workers only to hire them back as
independent contractors. The Department of Labor applies a similar test to that of the IRS in
determining whether the rehired worker is really just doing the same thing but with a different
status.
The Tax Translator – Steve Hoffman
Steve@TheTaxTranslator.com
732.853.4721
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"We recommend businesses conduct a comprehensive audit of the written independent contractor
agreements in place," Idalski says. "Provisions covering the day-to-day operations, who does
what, who's in charge, equipment, policies and procedures should be included."
SHIFT CHANGES
Common situations where an unintended misclassification occurs involve "semi-retiring workers
who, because they are scaling back in hours worked, may be shifted from full-time employee to
contractor status while they are performing the same functions. Or sometimes a worker requests
that the worker's business be hired instead of adding the worker to the payroll," Cryan explains.
The 20-factor IRS test offers guidance when classifying workers. The degree of importance
afforded any one factor depends on the context in which services are performed. If worker
misclassification occurs, section 530 of the Revenue Act of 1978 provides "safe harbor"
treatment when the business shows:
1) There was a reasonable basis for treating a worker as an independent contractor.
2) It has treated substantially similar positions consistently.
3) All required federal tax returns were filed consistently with its treatment of the workers.
Because of the 20-factor test, both Labor and IRS audits are factually intensive, time-consuming
processes. Though no quick fix exists for a business experiencing these audits, minimizing the
tax hit may be possible.
"The IRS Classification Settlement Program can be a cost-efficient resolution for audited
businesses that have improperly classified workers," Cryan says. "Generally, 10 cents on the
dollar is a CSP settlement on additional amounts due. For a company to participate in the CSP, it
has to agree to be bound by the correct classification for future tax years."
The Tax Translator – Steve Hoffman
Steve@TheTaxTranslator.com
732.853.4721
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