Employee misclassification

guest commentary by David Potts

By now most business owners are aware of our government’s efforts to reduce the tax gap. The tax gap is the difference between what individuals and companies should be paying in taxes each year based on existing laws and the amount of taxes they are voluntarily paying each year.

An area Congress has shown interest recently is the misclassification of employees as independent contractors. Several bills have been introduced in the 111th Congress to address these concerns, though none have passed as of  this date.

Last Tuesday, the Congressional Research Service published a report titled "Tax Gap: Misclassification of Employees as Independent Contractors.” These research reports are prepared at the request of members of Congress when Congress has a current interest in the subject. Their current interest, of course, is raising additional tax revenues. This report explains how the misclassification of employees as independent contractors contributes to the tax gap. In the second paragraph of the report’s summary it states: "A business owner must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In contrast, a business owner does not have to withhold or pay any taxes on payments to independent contractors. Employers are more likely to withhold and submit taxes than independent contractors are to voluntarily pay their tax liabilities."

To paraphrase the problem Potts style, businesses are paying too many people as independent contractors rather than employees to avoid paying Social Security, Medicare, and unemployment taxes. Independent contractors don’t report all their income on their tax returns because businesses sometimes fail to report the amounts paid to them on 1099‘s. If they were classified as employees, their earnings would be reported to the IRS on a W2. Since so many independent contractors cheat on their income taxes, Congress wants businesses to correctly classify these independent contractors as employees.

(Of course, if the rates weren’t so oppressive for self-employed independent contractors, there would be less temptation to cheat. It’s common for a small independent contractor to pay one-third of what he or she makes in Federal and state income taxes and Federal self-employment taxes. But hey, I pay my taxes. So should they.)

Failure to correctly classify workers as employees can cost businesses significant money in penalties imposed by the IRS. So if you own a business and you pay workers as independent contractors, you might want to consider whether they should be classified as employees.

The IRS looks at three areas of evidence to determine whether the worker is an employee or independent contractor: behavioral control, financial control, and the relationship of the parties.

Behavioral control considers to what degree you instruct the worker on how to complete the job and the degree of training you provide to the worker. According to the IRS, by definition an employee is subject to a business’ specific instructions about when, where, and how to work. The more detailed instructions the more likely the worker is an employee. If the business trains the worker on how to do his job, he is more likely to be considered an employee than independent contractor. Independent contractors usually use their own methods to complete a job and on their own time table.

The factors the IRS uses to consider a workers financial control include significant investment, unreimbursed expenses, opportunity for profit or loss, services available to the market, and method of payment. An independent contractor is more likely to have an investment in his own equipment, out-of-pocket expenses that are not reimbursed, the opportunity to lose money, to work for more than one business or individual, and to get paid by the job not the hour.

In considering the relationship between the worker and the business the IRS considers written contracts, employee benefits, permanency of the relationship, and services available to the market.

It is not uncommon for a business and a worker to have a contract that states the worker is independent contractor. The existence of contract does not mean the IRS will consider the worker an independent contractor. The determining factor is how the parties work together. Also, independent contractors generally don’t receive employee benefits or work for the business indefinitely. They often advertise and maintain a visible business location.

Whether a worker is an independent contractor or employee depends on many factors and these factors aren’t black-and-white. If you are paying workers as independent contractors, it might be prudent to discuss your exposure and risks related to the potential misclassification of these workers with your CPA. Why? The February 2010 Journal of Accountancy reported that “the IRS … announced that it will conduct intensive employment tax audits under its National Research Program (NRP). This is a multiyear program with random audits scheduled to begin in February 2010. The IRS has said it will audit approximately 6,000 U.S. companies under this program. … NRP audits are random to allow the IRS to statistically measure the total amount of noncompliance in a specific area. The IRS then uses this data to update its computers and estimates of the tax gap — the difference between total taxes owed and the amount actually paid by taxpayers.”

In the near future, enforcement of worker classification may be more intense.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]