IRS Audits: Worker Classification

The IRS has the burden of proof when it interrogates an employer about its worker classifications. Before the Small Business Job Protection Act of 1996, the onus was on the employer to prove that an individual didn’t qualify as an employee. But the current law does prohibit employers from relying on a prior audit to validate the classification unless the audit specifically examined the worker’s status.

Section 530 relief

Under revised IRS training manual guidelines, IRS agents must inform you of your so-called Section 530 relief. The law provides you with immunity from back employment taxes if the IRS reclassifies your contractors as employees.

However, employment law experts say many employers miss out on the tax break because IRS agents fail to explain it fully. If an agent doesn’t provide you with a copy of IRS Publication 1976 (9-96), he or she is breaking the rules.

While Section 530 does provide for back tax relief, the IRS will still require you to convert those workers to employees and begin paying payroll taxes. To be eligible for Section 530 relief, employers must prove that they:

  • Had a “reasonable basis” for treating the workers as independent contractors.
  • Regularly filed a Form 1099 for each worker.
  • Consistently classified all workers with similar jobs as independent contractors—never as employees.

To view a copy of the IRS’ revised training manual guidelines, go to

New IRS initiatives have also cut the tax liability from three years to one year for employers that misclassify workers. And in an effort to convince offenders to confess their misclassification of workers, the IRS launched a clemency program in 1996 whereby employers may be able to escape liability for back taxes if they agree to reclassify their workers. This applies only if firms notify the IRS before they are audited.

Form SS-8: Inviting a ruling

Despite these steps to simplify the process, many employers still find it daunting to classify their workers. The IRS’ attempts to streamline the classification test haven’t eliminated the complexity.

Case in point: Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Employers that submit this completed four-page form receive a written ruling from the IRS on whether an individual qualifies as an independent contractor. Revised in 2011, it remains a long, detailed and somewhat ambiguous document. Form SS-8 is designed as a checklist so that employers (or workers) can answer a series of questions based on the 20-point test, but the form leaves room for different interpretations.

In some cases, angry workers who think employers have misclassified them as independent contractors will file Form SS-8 to clarify their status. Although the individuals will receive an IRS ruling, they’ll also probably irritate their employer for attracting the IRS’ attention.

The IRS on patrol

Virtually every taxpayer dreads an IRS audit. For employers, it gets even worse. IRS agents can scrutinize your company’s books for days, demand reams of documentation and even interview dozens of individuals before making a ruling.

The IRS has only one chance to audit the same workers. That’s because the so-called prior-audit rule prohibits the agency from coming back and challenging the status of the same people again. But beware: Because the prior-audit rule—along with provisions in the Small Business Job Protection Act—makes it harder for the IRS to prove that workers are employees, tax investigators have designed a procedure that legally gives them another shot at your firm.

Called a “compliance check,” it’s not officially an audit, so you’re not facing as much potential liability. But business owners and managers alike should know the difference.

Compliance check or audit?

When the IRS contacts you to inspect your employment records on worker classification, your first question should be: Is this a compliance check or an audit? Here’s how to tell the difference:

Compliance checks. Basically, a compliance check is just a pop quiz on how you keep your payroll records. Under this procedure the IRS can:

  • Check your math on certain IRS forms you’ve completed (Form 1099 for independent contractors and Forms W-2, 940 and 941 for employees).
  • Ask you to correct errors.
  • Determine if the forms are completed and filed properly.
  • Ask if you understand the recordkeeping rules and provide information.

During a compliance check, the IRS can impose penalties for misfiled records, but this isn’t likely to happen.

Audits. The stakes get higher when the IRS launches a full-scale investigation of how you use and classify workers. During an audit the agent can:

  • Examine all your books and records.
  • Interrogate you in detail about the relationship between your freelancers and your full-time staff.
  • Suggest which staffers should be treated as contractors and which should be considered full-time employees.
  • Determine whether you’ve calculated all your tax liabilities correctly.
  • Determine whether employee reimbursements or fringe benefits you’ve paid are taxable.

In some cases, a compliance examiner might slip into an audit without warning. If you notice the IRS agent crossing the line into audit territory, take these steps:

  • Tell the agent that he is conducting an audit, not a compliance check.
  • State that you will claim your prior-audit right if you are audited in the future.
  • Demand a full audit report so that your freelancers are shielded under the prior-audit rule.

If you’re audited a second time within a few years, the IRS is allowed to examine workers who perform different jobs from those who were investigated during the prior audit. But if certain workers were deemed contractors during the first audit, the IRS cannot change its mind this time and reclassify them as employees.

Preventive steps

While sloppy preparation of 1099s is an obvious tip-off that you may be in violation of other tax regulations as well, you can take preventive steps to keep your organization out of harm’s way.

The most important step is to enforce uniformly the worker-status rules. For example, if you categorize some data entry workers as employees and others as contractors, you better have a well-documented reason for doing so. And if you give some contractors 1099s, send them to all outside workers.

Also, pay attention to the following issues to avoid messy lawsuits later:

  • Communicate your benefits policy. When distributing your benefits plan information, have independent contractors and leased employees acknowledge in writing that they aren’t covered, even if their classification is later changed and they become so-called common-law employees.
  • Have an accountant or attorney certify your worker classifications. For extra protection, ask him or her to provide a letter rendering an opinion about your workers’ status. You can use this document as evidence that you relied on professional advice. While it may not free you from liability, it will demonstrate that you made a good-faith effort to comply with the law.
  • Compose a contract. While formal contracts with independent contractors don’t offer total protection, they can reduce the odds that you’ll face tax penalties when the IRS comes calling. The contract should describe the work to be performed, the duration of the agreement and the amounts paid to the contractor. It should also state that no benefits will be provided and that the contractor is responsible for paying federal and state taxes. Also, have workers sign an acknowledgment that they have complied with applicable business licensing requirements and maintain their own employment records.

Audit blitz: IRS turning up the heat

If you classify any workers as “independent contractors”—or have plans to do so—make sure you get that classification correct. A massive new “Misclassification Initiative” launched by the IRS and the DOL is targeting employers with more audits and new scrutiny.

In 2010, the IRS began intensive audits of 6,000 randomly selected employers across all industries and company sizes. In addition to independent contractor status, the audits examine compliance in payroll taxes, fringe benefits and executive compensation. The audits mainly focus on tax years 2007 and 2008 and include face-to-face interviews, plus a line-by-line review of the companies’ employment tax returns. And as part of the crackdown, the DOL hired 100 new auditors solely to investigate misclassifications.

The federal government predicts its new crackdown on employee misclassification will reap at least $7 billion in federal revenue over the next 10 years. States are also cracking down on improper misclassification across the board.

Feds offering amnesty deal: Recently, the IRS unveiled a new Voluntary Classification Settlement Program (VCSP), which allows eligible taxpayer employers to voluntarily reclassify workers as employees for federal employment tax purposes. The program features partial amnesty for past misclassifications, limiting an employer’s liability.

Instead of paying penalties and interest for misclassifying workers, VCSP participants will be liable for just over 1% of the wages paid to those reclassified workers for the past year. No penalties or interest will be due, and the IRS will back off on audits related to these workers for earlier years. To learn more about the VCSP and find out if your organization qualifies, go to

Note: This new offer is strong incentive because the IRS and the DOL recently announced they’ve begun an information-sharing initiative with several states to “end the business practice of misclassifying employees.” The agreements should make it easier for both the states and feds to go after employers that misclassify.

DOL enlists states to conduct more audits

The DOL has opened a new front in its war to crack down on employers that misclassify workers as independent contractors: It’s helping states scour unemployment insurance records for evidence of misclassification.

In 2014, the DOL awarded grants totaling more than $10 million to 19 states to beef up worker misclassification detection and enforcement initiatives in their unemployment insurance programs. And, the DOL’s “high-performance bonus” program will funnel $2 million to the four states that rack up the greatest increases in detection of worker misclassification.

Form 1099: Handle With Care

The information you record on Form 1099 is a top audit target. Be sure your records are in order when the IRS comes to call. Form 1099 shows the payments you’ve made to your independent contractors, and the form must be mailed to your freelancers every year, postmarked by Jan. 31. 

If you mailed your 1099s on time and filed them properly in-house, you have a good chance of avoiding retroactive payroll taxes even if an auditor reclassifies your freelancers as employees. What is the auditor looking for? Here’s a checklist of common slip-ups:

  • The number of 1099s on file doesn’t match the number of contractors who work for your firm.
  • You have certified mail receipts to show that you mailed the forms on time, but you don’t have copies of all the forms on file.
  • You have all the forms on file, but you can’t show that you mailed them on time.
  • The payments recorded on your 1099s do not match your accounting records.

Of course, the IRS reviews other criteria. But if your 1099s are misfiled, you might be ineligible for other exclusions, and if so, you might get hit with three years’ worth of back payroll taxes. Even if the IRS approves the status of your workers, misfiled 1099s will cost you $50 per form.

Recommendation: When you mail your Forms 1099, be sure to include the phone number of someone in your firm who can answer contractors’ questions. If you forget to include the phone number, you’ll pay a penalty of $50 per form.