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How can you cut operating expenses down to size? Using more independent contractors might be the answer. But you can’t simply label workers as “independent contractors” when it suits your needs.

If the IRS reclassifies workers as employees, your company could be hit with a whopping bill for back employment taxes … with penalties and interest to boot.

Strategy: Stick to your guns for legit arrangements. In a pinch, you might rely on “Section 530 relief” to bail you out.

This special rule, written into law in Section 530 of the 1978 Revenue Act, allows you to claim independent contractor status for workers if you meet certain requirements (see related article).

The 20-questions test

Typically, the IRS uses a 20-factors test to determine if a particular worker is an independent contractor or an employee. The more control that your company exerts over a person—for example, setting work schedules, preventing the worker from employment with other companies and so on—the more likely the IRS will consider the individual an actual “employee.”

Be aware that the IRS isn’t shy about challenging employers on classifications.

4 ways to beat the IRS

To qualify for Section 530 relief, you must show a “reasonable basis” for treating a worker as an independent contractor. Any one of the following four methods will do the trick:

  1. The classification is a longstanding practice. It must be a significant segment of your industry or profession. “Long-standing” can mean less than 10 years, while a “significant segment” may be less than 25 percent.

    Strategy: Survey similar businesses and document the results. The IRS will want hard proof.
  2. The classification has survived an IRS audit. If the IRS has audited your business since 1996 regarding the employment-tax treatment of such workers and it allowed the classification to stand, you qualify under the “prior audit exception.” For audits conducted prior to 1997, it doesn’t matter if the audit involved worker-classification issues: You’re home free so long as you didn’t change how you treated the workers.
  3. You can provide an ironclad precedent. If you can find an authoritative court decision or an IRS ruling to support your position, you may meet the reasonableness test.
  4. You relied on a professional’s advice. Finally, you may avoid a tax disaster if you can show that you based your determination on a paid tax professional’s advice.

    Record your tax pro’s conclusions. Keep copies with your payroll tax documents. Make sure the professional signs off on the deal.

Note that you can’t qualify for Section 530 relief for a prior year if you fail to issue Form 1099s for workers you treated as independent contractors in that year (see related article).

Tip: The rules for Section 530 relief are summarized in IRS Publication 1976, Independent Contractor or Employee?, which can be found at www.irs.gov/pub/irs-pdf/p1976.pdf.

Online resources:

For more guidance on independent contractors, access our free, downloadable white papers, Independent Contractors: the Legal Boundaries, and Independent Contractor or Employee? How to Make the Call at www.SmallBizTax.net. Click on “Resources.”

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