Is my independent contractor really an "employee"?

The Internal Revenue Service is commencing and Employment Tax Study and starting in February 2010 the Internal Revenue Service plans to have 200 Revenue Officer Examiners begin a three-year research study on employment tax compliance.  Could your company be selected for review?  The IRS will select 2,000 taxpayers at random each year for comprehensive examinations to collect data on employment tax filers.  This is a very small percentage of taxpayers but those that are unlucky enough to be chosen will undergo a very grueling examination.

The main goals of the research project is to provide information for computing the employment tax gap and to determine compliance characteristics so the IRS can focus on the employment tax areas that are the most noncompliant.  The results of the study will allow the IRS to determine more accurately determine the extent to which businesses properly comply with employment tax law and related reporting requirements.  This will help the IRS select returns for audit that have the greatest non-compliance risk.

What will the IRS be focusing on in these audits?  Common areas of non-compliance are worker classification, fringe benefits, and officer compensation.   One of the areas the IRS has really been concentrating on is worker classification and they use a four factor approach to determine if an individual is an employee instead of an independent contractor. 

The first factor is the degree that the business has financial control over the individual and it has two basic prongs.

• If the business provides 80% or more of the individuals revenue
• If the business makes regular payments without regard to quality or quantity of work completed

The second factor is degree that the business has operational control over the individual and it has four basic prongs.

• Is the individual permitted to perform services for more than one business at a time?
• Is the individual required to be at a certain place at a certain time?
• Is the individual required to use the businesses methods and follow their instructions?
• Is the individual required to perform certain tasks in order?

The third factor is the degree that the individual has a risk of loss and it has three prongs.

• Does the individual have an investment in the tools used for the work?
• Is the individual responsible for expenses associated with the work?
• Is there a fixed price for the work?

 The fourth factor is whether there are attributes of an independent business and it has six prongs.

• Does the individual have a business checking account?
• Is there a business location?
• Is there a business telephone listing?
• Do they maintain books and records?
• Do they have regular financial information?
• Is the income reported as business income?

While there is no hard and fast rule that applies to every situation, the more the individual is controlled by being paid mainly by one business, is told when, where and how to perform by the business, is provided the means by which to perform the services by the business and maintains only a few if any of the attributes of being their own business they will be considered an employee.

New tools to help the IRS.  The IRS has another new tool to uncover businesses that are incorrectly paying individuals as independent contractors when they should be paying them as employees.  Form SS-8, Determination of Worker Status for Purposes of  Federal Employment Taxes and Income Tax Withholding, and Form 8919, Uncollected Social Security and Medicare Tax on Wages, are filed by an individual that was paid as an independent contractor and thinks they should have been paid as an employee.  When they file Form 8919 they pay only the employee portion of  Social Security and Medicare taxes leaving the IRS to come after the business for the rest.  That fact alone will instill a lot of motivation for persons to file this form.

Will this person be someone that currently works for you, enjoys the work they are doing, likes the way they are being paid, and wants to continue working for you?  Not very likely, but what about that disgruntled person that you were forced to lay-off in these trying economic times?  If that were to occur and the IRS determined they were correct it could be very costly for your company.  Furthermore, if a violation is determined, the IRS will likely audit payroll returns and 1099’s for present and past employees.

Once they have determined that there is tax due they can seek payment not only from the business but also any “responsible person”.  A responsible person is someone that had signatory authority on the bank account and, therefore, had the ability to pay the tax.  This person is generally an officer or owner of the business but may include other key management as well.  The IRS will also assess penalties and interest on the unpaid balance and can place a lien or levy on the property and bank accounts of both the business and the responsible parties.

While this can all sound pretty frightening, it can also be easily avoided by determining the proper classification of those that perform services for you.  We can assist you with this analysis and you may even find out that you have the opportunity to save money by making appropriate classification changes.