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2010 Planning: Independent Contractor vs. Employee

Currently, the likelihood of your business being involved in a worker classification or employment tax audit is increased because the IRS is aggressively attempting to reduce the “tax gap,” which is the annual shortfall between taxes owed and taxes paid. Employment tax noncompliance is estimated by the IRS to account for approximately $54 billion of the tax gap. Under-reporting of FICA makes up $14 billion; under-reporting of self-employment tax accounts for $39 billion; and under-reporting of unemployment tax accounts for $1 billion in lost revenue.

As a result of the Questionable Employment Tax Practice (QETP) initiative, in 2007 the IRS entered into agreements with workforce agencies in 29 states to share the results of employment tax examinations. These agreements provide a centralized, uniform means for the IRS and state employment officials to encourage compliance with federal and state employment tax requirements. In addition, for the 2008 through 2010 tax years, the IRS plans to examine 6000 randomly selected employers’ Forms 941, Employer’s Quarterly Federal Tax Return, as part of the National Research Program (NRP).

Because the existing worker classification rules are complex and ambiguous, much uncertainty surrounds their interpretation and application. The lack of a single, definitive test for classifying workers as either employees or independent contractors contributes significantly to the worker classification problem.

Therefore, understanding the difference between an employee and an independent contractor is very important. If you are an employer, you are required to withhold and contribute a matching amount of FICA and Medicare taxes from your employee’s income. However, if your workers are independent contractors, you are only required to report payments of $600 or more on a Form 1099-MISC (Miscellaneous Income). Failing to make the right classification could cost you money.

If you have workers who make substantial financial investments in tools, equipment, or a place to work, or undertake some entrepreneurial risks, they are probably independent contractors. However, when you control and direct the workers who perform services for you as to the end result and how it will be accomplished, you are probably involved in an employer-employee relationship.

Unless there is a reasonable basis for treating your employees as independent contractors, failing to withhold income and employment taxes from their wages can result in severe penalties and interest, in addition to the back taxes owed. Of course, penalties for intentional worker misclassifications are harsher than they are for inadvertent mistakes.

Your benefit plan may also be in jeopardy if any eligible employees have been misclassified as independent contractors. Since these employees have been excluded from plan participation, your retirement plan may lose its tax-favored status. The problem is compounded when excluded employees seek restitution for lost benefits not only due to their exclusion from the benefit plan, but also for health coverage and other employee benefits.

As you probably know, compensation paid to certain workers considered nonemployees is not subject to income tax withholding, FICA or FUTA taxes. Generally, qualified real estate agents and direct sellers are considered statutory nonemployees. For nonemployee classification purposes:

  • Qualified real estate agents must be salespersons (or the person who recruits, trains or supervises salespersons); licensed real estate agents; and compensated based upon their sales or other output, rather than the number of hours they worked.
  • Direct sellers must sell or solicit the sale of consumer products to a customer, or to a buyer for resale, in the home or other non-permanent retail establishment. Workers who perform services related to the delivery or distribution of newspapers or shopping news are also considered direct sellers.

As you probably know, sometimes workers are specifically designated as employees by the Internal Revenue Code even if the facts do not suggest an employer-employee relationship. Generally, the following types of workers are considered statutory employees:

  • Full-time traveling or city sales representatives;
  • Agent-drivers or commission-drivers;
  • Life insurance sales representatives; and
  • Home workers.

However, there are distinct rules for each worker type, and their employment tax treatment also varies. In addition, statutory employees must personally perform substantially all of the services required under your contract. These workers cannot have a material investment in your facilities, and your relationship with them must be ongoing.

If your business currently employs statutory employees, we feel that it would be beneficial for you to verify that your workers are properly classified. It is also important to review your employment tax records and procedures, to ensure that they are in compliance with IRS guidelines, especially in the event of an audit. Please contact our office at your earliest convenience to make an appointment.