Q: What is worker misclassification, and how does the IRS make this determination in business audits?

A: Business owners frequently deal with two types of workers: employees and independent contractors. For the IRS and tax purposes, the difference between the two is critical.

For each employee, the business owner is responsible to withhold and pay income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes on wages paid. When employing an independent contractor, generally speaking, the owner is not responsible for any of those taxes.

Since how a business classifies workers will drastically impact the business' tax burden, the IRS is on the lookout for any misclassification of employees as independent contractors and the cracking down on any unpaid employment taxes. In fact, the IRS in February 2010 launched extensive employment tax audits of 2,000 randomly selected employers in an effort to determine whether they were improperly misclassifying employees as independent contractors. The IRS will audit 2,000 more businesses in 2011 and 2012 respectively, bringing this initiate up to 6,000 total random audits.

There is no litmus test the IRS uses to determine whether a worker is an employee or independent contractor. Rather, it looks at the totality of the working relationship of an individual to determine that person's status. Therefore, a business that has a signed Independent Contractors Agreement with the "worker" does not guarantee the IRS will look at it through the same lens.

Among the factors considered by the IRS are (1) behavioral, (2) financial, and (3) type of relationship. The IRS looks to see, among the trail of evidence, whether the company controls or has the right to control what the worker does and how the worker does the job, how a worker is paid, whether expenses are reimbursed, who provides the materials and tools for the job, any written contract, what types of benefits the worker is entitled to, and the duration of the working relationship. If the IRS determines that an owner has no reasonable basis for classifying an employee as an independent contractor, the owner may be liable for employment taxes for that worker.

Also note that workers who believe they have been misclassified by their employer as independent contractors can report their share of uncollected Social Security and Medicare taxes due.

For business owners facing payroll tax problems or business audits due to worker misclassification, it is wise for them to seek out the counsel of an expert Certified Tax Resolution Specialist or qualified tax attorney.

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