Protect Yourself When Using Independent Contractors
June 1, 2008
(June 2008) It's less costly for companies to use independent contractors, but you may be inviting IRS trouble if you do. Know how to avert an audit or minimize tax exposure if you misclassified workers.
Worker classification is costing the government billions of dollars annually in unpaid taxes. The GAO
estimates that worker misclassification cost the federal government $2.72 billion in 2006 because of lost income tax, Social Security taxes, and federal unemployment taxes. In New York, one report
estimates that 10.3% of private sector employees are misclassified, resulting in underpayments of state unemployment insurance tax alone by more than $175 million annually.
If your workers are employees, then you, as the employer, is responsible for payroll taxes and must include these workers in your employee benefit plans, such as medical coverage and retirement plans, on a nondiscriminatory basis. In contrast, independent contractors (ICs) are responsible for their own taxes; you merely have to issue an annual Form 1099-MISC for any IC who earned $600 or more during the year. While ICs may charge more than you'd pay an employee, after factoring in employment taxes and the cost of other employer responsibilities, ICs usually cost less.
Unfortunately, you can't just say someone is an IC if he or she is really an employee. If you exercise control over when, where, and how the worker does a job, that worker is an employee and must be treated as such.
The IRS is aggressively seeking to reclassify workers where appropriate because of the tax dollars to be collected (it's easier to go after an employer with multiple workers than to individually find ICs who are not paying or underpaying their taxes).
IRS strategies include:
- Increased audit focus on payroll. Expect more tax audits on this issue. For example, the IRS has a computer-matching program to find companies paying $25,000 or more to purported ICs who do not work for anyone else.
- Cooperation with states. At present 33 states share data with the IRS following payroll examinations. For instance, if a state reclassifies a worker as an employee following his claim for unemployment compensation or disability pay, the state will share this information with the IRS.
- Tip-offs from workers. New Form 8919, NAME, lets workers that companies call ICs but who believe themselves to be employees to avoid paying self-employment tax. The IRS will undoubtedly look closely at forms filed with 2007 income tax returns of workers to uncover companies that are misclassifying workers.
What you can do
The key to not attracting an examination of your worker classification or coming out on the right side if you are examined is treating workers correctly from the start. Also take defensive action to minimize your penalty exposure if you do misclassify workers.
Learn the rules that the IRS follows in classifying workers.
It has created a training manual
for its examiners to use when auditing employers.
Follow the safe harbor rule created by a 1978 law. Even if a worker is reclassified, youíll avoid penalties. To rely on the safe harbor you must:
- Issue a Form 1099-MISC if you pay anyone $600 or more in total during the year.
- Have a reasonable basis for classifying the worker as an IC, such as (1) an industry practice that treats certain workers as ICs, (2) a court decision or IRS ruling, or (3) a prior IRS audit that did not change your worker classification.
- Classify all workers the same who do the same work.
Caution: Congress may end reliance on industry practice as a way to escape worker classification (we"ll keep you posted).
Use independent contractor agreements. While having a worker sign a contract is no guarantee that the government will agree with your worker classification, it can go a long way in helping to avoid problems. It informs the worker that he or she is being classified by you as an independent contractor and is responsible for his or her own taxes. Before using an agreement, think through the reality of the arrangement to see that it truly is one of "company and IC"and not one of "employer and employee."