IRS aims to correct worker misclassification
Misclassification of employees as independent contractors - intentional or otherwise - is a national issue that affects millions of workers and results in billions of dollars in lost tax revenue.
Recent studies conducted by both the Treasury Inspector General for Tax Administration and the U.S. Government Accountability Office indicate that the employee codification problem is a growing contributor to the $345 billion tax gap, and the Internal Revenue Service intends to make the issue a significant part of its National Research Program audits slated for early next year.
"This is a natural progression in using the NRP to take a limited sample of returns to get a data measurement as to where they should be focusing their audits in the future," said Benson Goldstein, senior technical manager for tax at the American Institute of CPAs. "Since small business has been one of the areas of concern with respect to the tax gap, small business will be a significant focus of the employment tax initiative."
Although the full extent of employee misclassification is not known, the last comprehensive study, in 1984, estimated that U.S. employers misclassified a total of 3.4 million employees, resulting in an estimated revenue loss of $1.6 billion in 1984 dollars. The Department of Labor commissioned a study in 2000 that found that between 10 percent and 30 percent of companies audited in nine states misclassified at least some employees.
Since federal employment taxes are imposed only with respect to wages paid to employees, the IRS is the agency responsible for determining whether a worker qualifies as an employee or an independent contractor. And since employee status is defined slightly differently for the purposes of the three different employment taxes - FICA, FITA and income tax withholding - status must be determined separately for purposes of each.
Generally, a person is an employee if they are subject to another's right to control the manner and means of performing the work; independent contractors, on the other hand, obtain customers on their own to provide services and are not subject to control over the manner in which they perform their services.
"There's a 20-factor test," explained Goldstein. "It's an issue of who has control, does the person set their own hours, who makes decisions as to how the work gets done. You don't have to have all 20 factors, but they are evidence of the different attributes of what may constitute an independent contractor."
"This is an issue that lacks a lot of clarity," declared Bill Rys, tax counsel for the National Federation of Independent Business. "One side of the issue is creating some clarity, and the other side is the chase for revenue. If that means more audits of small-business owners, that's one way to go about it."
NOT ALWAYS A MISTAKE
Aside from the inadvertent misclassification, there are a number of incentives for an employer to misclassify an employee as an independent contractor. Employers are responsible for matching the Social Security and Medicare tax payments their employees make and paying all federal unemployment taxes and a portion of or all state unemployment taxes, while independent contractors are responsible for paying their own Social Security and Medicare tax liabilities and do not pay unemployment taxes. In addition, misclassification allows employees to avoid having to comply with a number of federal and state laws regarding employment practices, and to avoid the scrutiny of federal workplace protection laws.
"The accountant's job is to advise the client as to what makes someone an independent contractor or an employee," said F. Gordon Spoor, CPA-PFS, of St. Petersburg, Fla.-based Spoor & Associates. "That's easy to do when the employer tells you he has no employees, but you drive by his business and see trucks and workers. The hard part is when they have 80 employees and represent that there are 20 independent contractors. In that case you usually don't get concerned, because it appears the owner knows what he's doing, yet some of those contractors may in fact be employees."
"It comes down to how much time you have to devote to the issue," he said. "And it's the same problem for the IRS. The obvious ones are easy, but it's the hidden ones that will always get you on an audit."
"The biggest part of the problem is explaining the issue to your client," said Greta Barncord, EA, president of the National Society of Tax Professionals. "Most of them don't have the foggiest idea what the difference is between an employee and an independent contractor. You can give them something to read, but they won't do it - they come to us for advice."
James Nolen, president of the National Society of Accountants, agreed. "Small-business owners don't begin to comprehend the issues involved, nor the amount of money that might be due if they misclassify a worker," he said. "It's not just the employer's share. They may be liable for the employee's share, plus penalties, plus 20 percent backup withholding - unless they can prove the employee reported and paid it. But in most cases the employee is long gone."
"On top of that there's the federal and state unemployment taxes plus penalties and interest, and perhaps worker's compensation, depending on the state," he said.
The GAO noted that some workers may agree to be misclassified as independent contractors in order to be paid in cash, avoid withholding of taxes, or prevent having to provide proof of their immigration status, but other workers may not realize that they have been misclassified. "In addition, they may not realize that as independent contractors, they are not covered under many laws designed to protect employees, and that they have obligations for which employees are not responsible, such as payment of their own taxes over the course of the year," the GAO stated.
Rather than explain the intricacies of the law and regulations to his clients, Nolen draws an analogy. "I explain to them that their relationship with me or an attorney is how to think about contract labor. I have my own business, my own equipment, and I decide when I'm going to do the work that they want done. Every inch they move away from that type of relationship, they're moving toward an employee relationship. So I ask them about a particular worker: Does he work for someone else as well, does he come and go whenever he feels like it, and does he have all of his own equipment? They'll say, 'How much will it cost me to call him an employee?' It gets particularly onerous when you have a tax-season-only client, so they've been doing this for a year before you're aware they're doing it."
"Social Security and Medicare taxes are trust fund amounts," Nolen cautioned. "The IRS can't forgive these; it's just the agency that collects them. And it's not a good idea to go to the bank and ask for a loan to pay back payroll taxes. Some businesses are thrown into bankruptcy as a result."
"It's a challenging issue," said the NFIB's Rys. "There have been a number of efforts in the past to provide clearer and simpler tests. If we can provide more clarity, it will mean fewer mistakes, and less opportunity for bad actors who want to get around the law."
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