Something to be aware of

I know that everybody likes to treat workers as independent contractors instead of employees because it's easier and most of the time cheaper. However, please be aware that just because you treat them as independent contractors doesn't necessarily make them so.

When I owned my accounting firm, the IRS periodically made checking on these classifications an important process. And now that tax revenues are down, they are doing it again. To wit:

The IRS recently announced it is closely examining worker classifications as part of its National Research Program (NRP) Payroll Audit. The three-year NRP payroll tax audit began back in February, 2010. As part of the program, the IRS is randomly selecting 2,000 returns from various employers in the private, not-for-profit and government sectors.

This issue has long been a concern for the nation's tax collectors. Reason: The IRS frequently maintains that employees have been misclassified as independent contractors. It estimates that employment tax underreporting accounts for about $54 billion of the $345 billion tax gap (which is the difference between what taxpayers owe and what they pay).

Basic differences: If a worker is classified as an employee, the employer must withhold federal income tax and the employee's share of employment taxes. In addition, the employer is responsible for paying its share of the employment taxes. The employer must also issue a Form W-2 for wages earned and send a copy to the IRS.

Conversely, if a worker qualifies as an independent contractor, the employer isn't responsible for employment taxes, withholding or the fringe benefits it offers to full-time employees. All the organization has to do is send a Form 1099 to the worker each year with a copy going to the IRS.

Whether or not a particular worker should be classified as an independent contractor generally depends on the level of control the employer exerts over the worker.

Rule of thumb: The greater the control, the more likely the worker will be treated as an employee.

How the IRS Makes a Determination
Unfortunately, no single factor determines a worker's status by the IRS, other government agencies or the courts. Each situation is determined by the facts and circumstances involved.

The key is to look at the entire relationship your business has with independent contractors. Consult with your tax adviser about how to proceed if you are unsure.

Here are some of the factors the IRS considers to determine if a worker is an employee:
• Behavioral Control - An employee generally is told when, where, and how to work, as well as what order or sequence to follow.
• Tools - An employer usually gives tools, equipment and workspace to employees. In contrast, subcontractors often provide and invest their own money in equipment, tools and facilities.
• Assistants - Employees don't hire and pay others to help them do their jobs (although they may be told to hire assistants for the company). In contrast, contractors often hire, supervise, and pay their own assistants.
• Training - Employees are more likely to receive training from an organization than independent contractors.
• Other Customers - Independent contractors generally make services available to the public and are able to work for two or more businesses.
• Integral Role - An employer-employee relationship is supported when workers perform a service essential to the success of a business operation.
• Benefits - Are there employee type benefits (such as a pension plan, health insurance or vacation pay)?
• Financial Control and Risk - An employer has the right to control the financial aspects of a job, such as the business expenses the employee incurs and how staff members are paid. On the other hand, a worker's opportunity to personally earn a profit and assume risk of loss may indicate a non-employee status.

There are several steps a business can take to increase the chance that workers are properly classified as independent contractors.

Have written, signed contracts with workers classified as independent contractors, spelling out the terms and conditions of the relationship. Consult with your attorney in the preparation of contracts.

Once contracts are in place, give outside workers leeway over how they perform their duties. Resist the urge to supervise them the way you oversee employees.
Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year. The annual deadline for sending these forms is January 31.
Consistently treat workers performing similar tasks as either independent contractors or employees. Don't supply outside workers with services you give employees. Some companies run into trouble after they provide office space, computers, cars and other perks.

Maintain good records. Obviously, you need to keep an independent contractor's taxpayer ID number and other information required by the IRS, but you should also keep items that help prove the person is self-employed. For example, business cards, a letterhead, invoices and advertisements placed in newspapers. Keep copies of business licenses and print out a contractors' Web site pages showing that services are offered to the public. A simple listing in the yellow pages of the phone book is sometimes enough to convince an IRS auditor that an independent contractor is in business for him or herself.

Do a self-audit of each worker's or each class of workers' status before a federal or state agency conducts one.

Have your tax adviser or attorney familiar with employment law in your state conduct an audit of each worker's status.

Conclusion: Employers that misclassify workers as independent contractors can end up with substantial tax bills as well as penalties for failing to pay employment taxes. They may also face employee benefit liability. In some cases, workers sue for benefits they claim they were eligible for, including overtime, health insurance and retirement plan contributions.

I just wanted you to be aware of this so you don't get caught in their web.