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If your organization uses independent contractors, watch out: Starting in February, the IRS will begin intensive audits of 6,000 randomly selected employers. One key target: identify employers that are improperly misclassifying employees as independent contractors.

These National Research Program (NRP) audits are the IRS’ “most significant audit initiative in decades,” according to a report by law firm Morgan Lewis. The audits will generate the IRS’ first statistical snapshot of employment tax compliance since 1984.

In addition to independent contractor status, the audits—which will stretch across all industries and company sizes—will examine compliance in payroll taxes, fringe benefits and executive compensation. The audits will mainly focus on tax years 2007 and 2008 and include face-to-face interviews, plus a line-by-line review of the company’s employment tax returns. 

Misclassification on the rise. IRS officials believe tough economic times have led more employers to classify members of their workforce—often incorrectly—as independent contractors.

Slapping the contractor label on a worker saves the employer money, as they don’t need to pay for independent contractors’ insurance, benefits or for the employers’ half of the Social Security and Medicare taxes on workers’ wages.

But if the IRS, Department of Labor or a state agency determines that you’ve misclassified workers, the mistake can lead to tremendous liability. In addition to overtime, your former independent contractors may seek employee status to collect workers’ comp, unemployment benefits or damages in a civil rights lawsuit.

Making the decision. The fault line in the great “employee or contractor” divide lies in how much control the employer has over the worker’s schedule, materials, behavior, risk level, etc. Labels don’t count. If it works like an employee and is paid like an employee, it’s probably an employee.

The last time the IRS studied misclassification, in 1984, it estimated that about 15% of employers nationally misclassified a total of 3.4 million employees as independent contractors. A 2005 government report said 10.3 million American workers—or about 7.4% of the workforce—were classified as independent contractors.

FedEx is the poster child for the contractor battle. The IRS originally hit the company with a $319 million tax assessment for improperly classifying 12,000 of its drivers as independent contractors. But in November, the IRS backed off the assessment and allowed the workers to be classified as employees. Still, several states aren’t giving up the fight ... they plan to sue FedEx over those classifications.

FedEx isn’t the only state target. States are cracking down on improper misclassifications across the board. To read a state-by-state summary of recently enacted laws on independent contractor misclassification, go to www.theHRSpecialist.com/contractor-state.

How to respond if you are audited

If your company is selected for examination, follow good IRS examination management practices, including:

  1. Designate a clear chain of command for responding to IRS communications
  2. Retain expert outside advisors early in the process
  3. Maintain control over the IRS audit by requesting additional time to respond to information document requests, or tailoring the scope of information requested, where appropriate.

Online resources: For more advice, read our white paper, Independent Contractor or Employee? How to Make the Call at www.theHRSpecialist.com/contractor.

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