IRS Cracking Down on Misclassified Employees

by Robert Moskowitz on March 19, 2013
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Forewarned is forearmed: The Internal Revenue Service is examining the tax filings of small businesses in a special effort to find owners who are misreporting employees as “contractors.”

The IRS believes that some owners do this intentionally to avoid paying payroll taxes, Social Security, Medicare, and unemployment insurance. Whether intentional or not, the practice of treating employees as contractors may be shortchanging the government by several billion dollars each year [PDF].

At the moment, only about 6,000 of the nation’s 23 million small businesses are being audited for misclassifying workers, Fox Business reports. But the IRS estimates that as many as 30 percent of all employees are being wrongly classified as contractors, so many more companies could fall under the federal tax agency’s microscope in the future.

What’s the Relationship?

According to the IRS,  determining whether or not a person is legitimately a contractor is critical to complying with tax laws. Although there are 20 different factors to consider [PDF], determining whether someone is an “employee” or a “contractor” generally hinges on such matters as:

1. Oversight — How much authority does your company have to control the work the person performs and the way the person performs that work?

2. Money — How thoroughly does your company control funds, such as the worker’s pay, his or her reimbursement for expenditures, and the purchase of work-related tools, equipment, and supplies?

3. Other Elements — To the extent that a worker signs an employment contract, receives vacation and sick pay, gets insurance coverage, vests in a pension plan, performs vital work for the company, and seems locked into doing more of the same work in the future, he or she appears more like an employee than a contractor to the IRS.

Complicating the situation, certain industries — including limousine services [PDF] and moving companies [PDF] — are subject to different rules.

Getting It Straight

If you’re not certain about any of this, and you want to be, you (or a worker) may file Form SS-8 [PDF], which asks the IRS to review the facts and circumstances of your specific situation and officially determine the worker’s status for purposes of federal employment taxes and income tax withholding. Note: This process can take up to six months.

The IRS’s newly expanded Voluntary Worker Classification Settlement Program lets small-business owners properly reclassify workers as employees. Participants may receive partial relief from federal employment taxes and an IRS promise not to audit how the business classified its workers in prior years.

If an employee has been mistakenly treated as a contractor, he or she may file Form 8949 to recalculate the proper contribution to his or her Social Security and Medicare accounts.

Robert Moskowitz is a business writer for Intuit and is passionate about solving small business problems.

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