Should your independent contractors really be employees?

Internal Revenue Service (IRS) (Photo credit: cliff1066™)

The IRS, U.S. Department of Labor and state governments have a big stake in correctly classifying workers. Improper treatment of workers as independent contractors costs the government tax revenue, in the form of lost withholding, unemployment, workers’ compensation, and Social Security and Medicare taxes. This opportunity for reclaiming revenue has led to renewed compliance efforts. How big is the problem? Even with the interest in proper classification, it is not clear how many workers are misclassified. According to U.S. Bureau of Labor Statistics, contractors made up 7.4% of all workers in 2005 equating to 10.3 million workers. With the recent economic stress on small businesses, chances are that the use of contractors has increased significantly since 2005.



A 2011 MBO Partners study found that about 16 million workers were classified as independent contractors and predicted an even greater use of independent contractors in the next 10 years. After all, independent contractors are about 30% cheaper than employees and come without many burdensome employment rules compelling incentives for businesses. A 2000 Department of Labor (DOL) study revealed that 10% to 30% of all employers misclassify workers. In 2008, the IRS found that even when workers and employers asked the IRS for proper classification

English: logo of MBO Partners (Photo credit: Wikipedia)

, only 3% of the workers in question were independent contractors. However, the IRS does not have current, definitive numbers. The last definitive study on the issue was conducted in 1984 and concluded that 15% of employers misclassified 3.4 million workers as independent contractors. The IRS is stepping up worker reclassification efforts, which represent a substantial revenue opportunity. In fact, a 2009 U.S. Government Accountability Office report stated that 71% of IRS worker misclassification examinations result in changes to worker status. The IRS is quantify levels of worker misclassification, and the IRS and many states expect the study to reveal significant noncompliance.

What is the government’s stake in correctly classifying workers? The IRS knows that it is easier to keep employees compliant than independent contractors. The latest IRS tax gap study shows that Form W-2 employees misreport only 1% of their income, while, on average, independent contractors misreport 8% of their income. For the IRS, employee status means more automated, less expensive post-filing compliance activity, such as underreporter notices. Employee status is even more important in light of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, which mandates that employers with at least 50 full-time employees provide health care insurance or pay a stiff penalty. The mandate goes into effect in 2014, but employers may

Kaiser Family Foundation Affordable Care Act Poll (Photo credit: Vince_Lamb)

already be trying to reduce payrolls to avoid new taxes and requirements under PPACA. One way employers may reduce payrolls is by treating workers as independent contractors, rather than employees. Worker reclassification has also been of interest to the Obama administration. In 2011, the DOL confirmed its commitment to use audit and enforcement resources to address the growing problem of employee misclassification. There is also a coordinated effort among the IRS, DOL and many states to share audit findings and pool resources to address worker classification. At the 2012 IRS Tax Forum, held from July 31 to Aug. 2 in Las Vegas, IRS officials said that the IRS is coordinating employment tax examination findings with 37 states. Despite the problem, the IRS does not have a clear, bright-line test to determine the proper classification of workers.

Traditionally, the IRS has used the 20 common law factors found in Rev. Rul. 87-41 to test whether a worker is an independent contractor or an employee. Over the years, the IRS has tried to simplify determinations without much success. To complicate matters further, since 1978, IRS worker reclassification efforts have been hampered by defenses under Section 530 of the Revenue Act of 1978, which provided employers with safe harbors, such as reliance on a prior IRS audit or a long-standing industry practice. As a result, reclassification audits often led to long disputes in IRS appeals offices. To combat the enforcement stalemates, in 1996, the IRS instituted an early resolution program that could be used to settle audit disputes.

The Classification Settlement Program (CSP) allowed for prospective treatment of workers as employees but limited the taxes owed due to reclassification. In 2011, the IRS began the Voluntary Compliance Settlement Program (VCSP), which allows an employer to seek prospective treatment for workers and pay even less than under the CSP arrangement, but the program is purely voluntary. It is not available for taxpayers in an employment tax audit conducted by the IRS, DOL or state agencies. Since the program started, the IRS has received only 625 applications, according to officials at the 2012 Carolinas Tax Forum, held Aug. 8–10 in Charlotte, N.C.

Article by Jim Buttonow – cpa2biz.com – September 26, 2012

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