As technology continues to expand, and the popularity of “on demand” products and services explodes, many companies are altering their approaches to procuring labor. More and more are turning to independent contractors to meet their labor needs. Doing so often enables a company to deploy workers more quickly and efficiently and there’s no requirement to enroll these workers in a benefits program. But there’s a major compliance risk should the IRS believe an independent contractor is actually an employee.
The driving force behind the regulatory interest in independent contractors can be summed up in two words: tax revenue. When a company engages an independent contractor, it doesn’t need to withhold payroll or income taxes from his or her compensation. In addition, the business doesn’t have to remit its obligatory percentage of FICA or Medicare taxes, or pay into unemployment and workers’ compensation insurance.
As a result, when an employer misclassifies an employee as an independent contractor, the federal government potentially loses out on quite a bit of money. (Although their rules differ, states say they are also looking closely at this issue.) If the IRS determines you’ve committed employee misclassification, you could be held liable for unpaid federal and state income tax withholding; unpaid Social Security, Medicare and unemployment insurance contributions, and penalties and interest.
Moreover, you could be on the hook for both your company’s share and the employee’s share of these amounts. And this may hold true even if you’ve filed Form 1099 and paid all taxes due.
It’s important to keep in mind that the federal government isn’t the only one that may raise the issue. Often, former workers who were classified as independent contractors will file lawsuits to recover employee benefits, overtime pay and unreimbursed business expenses or other amounts associated with employee status.
THREE KEY QUESTIONS
For many years, the IRS relied on a lengthy list of 20 factors to determine whether a worker is classified properly. More recently, the agency has condensed its scrutiny into three key questions:
Do you control the worker’s behavior? The agency looks at how, where and when job tasks are performed. If the employer in question requires a worker to adhere to a schedule or perform job responsibilities in very specific ways, the individual could be reclassified as an employee.
Do you control the worker financially? An independent contractor should, in the view of the IRS, indeed be independent. When such an individual becomes largely or wholly dependent on a single entity to generate income, he or she starts to veer toward employee status.
What is the true nature of the relationship? Informal agreements or those that go on for a long time can start to look like employment. The IRS will check into the existence of a current contract with a worker that states a time frame, scope of work and desired objective.
STATE OF THE VCSP
About five years ago, the IRS made some waves by introducing its Voluntary Classification Settlement Program (VCSP). Through this initiative, the agency offers to reduce liability for back taxes for qualified employers that will reclassify groups of workers from independent contractors to employees.
To be eligible, an employer must have consistently treated the workers in question as “nonemployees” and have filed the required Forms 1099 for the preceding three years. The employer also cannot be undergoing an employment tax or Department of Labor audit. Other types of audits, however, don’t bar enrollment.
Qualified employers must finalize and sign a “closing agreement” with the IRS. Generally, the agreement stipulates that, in exchange for reclassifying the independent contractors as employees, back taxes due will be reduced to 10 percent of the amount that would have been due on compensation paid to those misclassified workers for the most recent tax year.
So how’s the VCSP been doing? Anecdotal reports suggest that relatively few employers are giving it a go. Initially, there was much concern among business owners about contacting the IRS and essentially admitting to misclassifying employees. In fact, the agency had to issue guidance reassuring employers that it wouldn’t share VCSP applications with other agencies and rejection of an application wouldn’t trigger an audit, among other things.
Still, it’s probably safe to say that response to the program has been underwhelming. Most likely, the VCSP best suits employers with particularly substantial liability.
MOBILITY AND SCALABILITY
The proliferation of independent contractors in today’s working world has even spawned its own buzz term: “the 1099 economy.” With so many people able to work for themselves and the demand for independent contractors strong in an economy that so values mobility and scalability, the risk of employee misclassification will likely remain strong.
If you’re engaging independent contractors now or expect to do so in the future, be sure to protect yourself.
This has been a general discussion and is not intended as advice to anyone. Independent contract issues can be complex. Work closely with your tax and legal advisers to stay out of trouble with the IRS and other agencies.
Norman Grill is a certified public accountant and managing partner of Grill & Partners LLC, CPAs and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien. He can be reached at 203- 254-3880.