Employee vs. Independent Contractor – How to Correctly Classify Workers and Avoid IRS Employment Tax Audits
Employers must beware of the federal and state crackdowns on the use of independent contractors to avoid payroll tax problems and employment tax audits. But how do you distinguish between independent contractors and employees? More importantly, how does the IRS determine who owes unpaid employment taxes and who doesn’t? Consider these tips to make correct determinations of worker classifications and avoid the wrath of IRS audits for unpaid employment back taxes and payroll tax problems.
Business audits are on the rise as the treasury needs every penny of unpaid employment taxes it’s owed. While some companies deliberately misclassify their workers in order to escape offering health insurance and 401K plans to their employees, some business owners are flat out confused as to how to correctly classify their employees. How do you distinguish between independent contractors and employees? More importantly, how does the IRS determine who owes unpaid employment taxes and who doesn’t?
There’s a 20-point common law test, internal revenue code section 5-30, that determines whether a person is an employee or an independent contractor. So even though you may be treating a person as an independent contractor, in the eyes of the IRS and the 20-point common law test, that may not be the case. When making determinations of worker classifications, consider the following:
Tip #1 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: Ask yourself, “Who’s in charge?”
In business audits, the IRS uses three general criteria to determine the relationship between companies and workers:
• Behavioral Control – does the business direct or control how the work is done and what hours the employee works?
• Financial Control – does the business direct or control the financial and business aspects of the worker?
• Type of Relationship – how do the worker and business owner perceive their relationship?
The employment tax audit bottom line – if the company is determining only what work is done, their workers are probably independent contractors. On the other hand, if they control not only what is done, but how it is done (when, where, etc.), then the workers are probably employees.
Tip #2 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: Determine where the buck stops.
What risk of loss does the worker have? Do they pay for and use their own tools (computer, printer, high-speed, etc.), or do you provide them with what they need? When it comes to employment tax audits, the worker carrying the liability is an independent contractor.
Tip #3 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: Check the name on the check.
To avoid unpaid employment taxes, discover if your accounting department is writing checks to “Jane Doe” or “Jane Doe, Inc.” If the worker is doing business under a DBA fictitious business name, LLC or other organizational umbrella, an employment tax audit would most likely declare that person a contractor.
Tip #4 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: Ask them to sign an exclusivity agreement.
Most independent contractors juggle many clients at a time. If your worker refuses to sign an exclusivity agreement, they are likely working for other companies and consider themselves free agents. An employment tax audit or business audit would consider them an independent contractor.
Tip #5 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: Ask whether they want a W-2 or 1099.
If you’re in need for tax relief the best defense against unpaid employment taxes is in the paperwork. An experienced independent contractor will ask for a 1099 form and pay their own taxes to avoid payroll tax problems. If you’re hiring an independent contractor for the first time, it is incumbent upon you to ensure that they know what their responsibilities are and avoid unpaid employment taxes.
Imagine this nightmare scenario: At some point in the future, a former worker of yours applies to the state for unemployment compensation. If no one has ever filed wages for that person, they may be forced to ask, “What is that about? I worked there 9 to 5, 40 hours a week, and they gave me an hour for lunch. I worked for them.” At that point, as a business owner your payroll tax problems have just spiraled out of control. The state unemployment compensation board is going to notify the state Department of Revenue of your possible unpaid employment taxes and audit your business. In 22 states this will quickly be followed by a knock on the door from the IRS and a federal business audit.
However, if you can show them a signed agreement where the worker acknowledged their rights and responsibilities as an independent contractor, you’re going to save yourself the huge headache of unpaid employment taxes or payroll tax problems, a business audit and the possible shut-down of your business.
Tip #6 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes: When in doubt, ask the IRS to make the determination.
Both employers and workers can ask the IRS to determine whether a worker is an independent contractor or an employee. All you need to do is file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. They will apply a 20-point common law test, internal revenue code section 5-30, that determines whether that person is an employee or an independent contractor.
I recommend that you do more research to avoid unpaid employment taxes or payroll tax problems by learning more about the difference between independent contractors and employees at www.irs.gov (select the Small Business link). Additional resources include IRS Publication 15-A, Employer’s Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS website or by calling the IRS at 800-829-3676 (800-TAX-FORM).
There is a fine line between hiring employees versus independent contractors. In order to avoid unpaid employment taxes or payroll tax problems you should research the facts, correctly classify all workers, ensure that they are aware of their rights and responsibilities and have the paperwork close at hand to avoid a business audit.
For more information on achieving a tax resolution for your IRS problems, visit www.taxresolution.com for a free tax relief consultation or call 888-699-7630.
Michael Rozbruch, one of the nation’s leading tax experts, is a Certified Tax Resolution Specialist (CTRS), licensed CPA in the state of Maryland and the founder of Tax Resolution Services (http://www.taxresolution.com). He teams up with an expert staff of tax attorneys, CPAs, and tax relief professionals to help individuals and small businesses solve their IRS problems with tax liens, unfiled back taxes, offers in compromise, wage levies, tax relief, delinquent returns, tax debt installment plans, bankruptcy and protecting an innocent spouse from unfair tax burdens.
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