By Alexandra DeFelice
If your clients have workers they consider to be independent contractors, you may want to drill down to ensure they are classifying them correctly and they're not actually employees in the eyes of the government.
This topic was addressed at the New York State Society of CPAs (NYSSCPA)CFOs, Controllers, Treasurers, and Financial Professionals Conference in New York City July 17.
Improper classification of workers as independent contractors versus employees causes myriad problems for employers, states, and workers, according to the society's presenter Avery E. Neumark, CPA, JD, partner and director of Employee Benefits and Executive Compensation at Rosen Seymour Shapss Martin & Company LLP.
State studies show up to 60 percent of companies misclassify workers as independent contractors, resulting in $9.5 million in back wages being collected by the IRS since 2011. Why? Because the employers have avoided paying not only income taxes deducted from the workers' wages, but also FICA (Social Security and Medicare) deducted from the workers' wages and FUTA (federal unemployment) paid by the employer.
Neumark highlighted some estimates to underscore why the government is going after employment taxes:
- FICA taxes estimated at $14 billion are underreported.
- Unemployment taxes estimated at $1 billion are underreported.
- Self-employment taxes estimated at $39 billion are underreported.
- $5 billion are underpaid in the above three categories.
- Non-filed amounts in the above three categories are inestimable.
When the IRS expanded its National Research Program in 2009 to include tax compliance related to employment taxes, it started with sixty-one misclassification audits. The best and most experienced auditors were brought in and were provided special training to determine if those sixty-one companies – nonprofits, professional services companies, construction companies, and others – were in compliance. From 2010 through 2013, more than 6,000 audits were conducted because of all the reclassification issues uncovered in 2009, according to Neumark.
Now, if a company receives an IRS audit notification letter, the audit isn't simply going to be a review of forms 941 (reporting income and employment taxes withheld) and forms 940 (FUTA taxes) for the tax year, according to Neumark. "The IRS intends to drill down on the compensation that generated the withholding and then audit those various compensatory components for reporting compliance as well", he said. "They'll be reviewing fringe benefits, like personal use of aircrafts, and nonqualified plans to see if they're being reported properly."
And they won't need to ask the company for the files when they knock on the door, because the auditors will have already looked into them in advance. Plus, the IRS and Department of Labor have agreements with roughly thirty states, which allow them to share information and, therefore, collect more money. The red flag that often waves in the air for the government to see is when a so-called independent contractor files for worker's compensation or unemployment and there's no record of that person being an employee.
So how do you know who the government considers and employee versus an independent contractor? Focus on one word: Control.
Prior to 2007, the IRS used a twenty-factor test to determine the difference. According to the IRS, it now uses the following three factors:
- Behavioral control: The facts that illustrate whether there's a right to direct or control how the worker performs the specific task for which he or she is engaged (e.g., instructions, training etc.).
- Financial control: The facts that illustrate whether there's a right to direct or control how the business aspects of the worker's activities are conducted (e.g., significant investment, unreimbursed expenses, method of payment, opportunity for profit or loss, etc.).
- Relationship of the parties: The facts that illustrate how the parties perceive their relationship (e.g., intent of the parties/written contracts, employee benefits, discharge/termination, regular business activity, etc.).
Ask yourself",Is this guy under too much control? If yes, he's likely an employee", Neumark said.
Whether workers are independent contractors or employees depends on the facts in each case, according to the IRS.
"The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done", according to the IRS website. "[However], there is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination."
So what can accountants do to protect themselves and their clients?
1. Update processes and procedures to ensure compliance.
2. Verify payroll system taxability and tax rates. Make sure proper documents are in place to show workers are really independent contractors.
3. Consider voluntary disclosures. The Voluntary Classification Settlement Program (VCSP) is an optional program that launched in 2012. It provides taxpayers with an opportunity to reclassify their workers as employees for future tax periods and requires them to pay only 10 percent of employment tax liability that would have been owed for the most recent tax year. Several factors must be considered to be eligible for this program, and the employer must fill out Form 8952, Application for Voluntary Classification Settlement Program.
Only about 1,000 companies have taken advantage of this program, which Neumark suspects is due to an unwarranted degree of confidence by companies that they won't get caught, or fear that it will expose them to other penalties.
4. Review Section 530 of the Revenue Act of 1978. This section protects companies from the IRS reclassifying their workers and collecting back taxes and excessive penalties if employers (1) can prove they had a reasonable basis to classify the workers as independent contractors; (2) were audited previously when they treated similar workers as independent contractors and the workers weren't reclassified; (3) can prove a significant segment of the industry treats such workers as independent contractors; or (4) relied on some other reasonable basis, such as the advice of an accountant or attorney, to classify the workers as independent contractors. The employers must also have consistently treated the workers as independent contractors and filed Form 1099-MISC for each such worker who earned $600 or more during the year in question.
Workers to evaluate include, but are not limited to, construction and janitorial workers, restaurant staff, nurse temps, cable television installers, home-based telecommuters, and even interns (if they're doing the work of an employee).
About the author:
Alexandra DeFelice is senior manager of communication and program development for Moore Stephens North America, and a regional member of Moore Stephens International Limited, a network of more than 360 accounting and consulting firms with nearly 650 offices in 100 countries. Alexandra can be reached at [email protected].