IRS Business Audits Rise on Contractor vs Employee Classifications

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IRS Business Audits Rise on Contractor vs Employee Classifications

IRS ramping up small business audits to determine whether small employers’ employee classifications for employees vs contractors is correct. Here’s what you need to know.

HR Mistakes with Employee Classifications Can Be Costly to Small Business

Claiming that some business owners have increased use of independent contractors and consultants to avoid paying Social Security and Medicare taxes, this year the Internal Revenue Service signaled that they would be taking a closer look at the way small business’ employee classifications. The Wall Street Journal recently reported that the US Internal Revenue Service (IRS) has ramped up payroll audits of small employers in an effort to find those who are mis-classifying workers in order to dodge taxes.

State studies have shown that local businesses mis-classify anywhere from 10 percent to more than 60 percent of their workers as independent contractors.” WSJ.com

While it may be no more than a reflection of how the economy has shifted, including (as Bloomberg’s Businessweek noted) a disproportionate rise in the cost of benefits and an increasing need for flexibility, there is no harm in taking a quick peek at your organization’s work force to be sure that your small business is in compliance with federal and state regulations regarding employee classifications.

To help you get started with your payroll review, we have included some helpful definitions and links to federal and state websites where you will find detailed employee classifications, wage and hour mandates that may be applicable to your small business.

3 Guidelines from the IRS for Accurate Employee Classifications

1. What – exactly – is an Employee?

Anyone who performs services for you is your employee if you can control what will be done and how it will be done.” (www.irs.gov) The IRS website goes on to define “common law rules” that can be used as criteria for determine whether someone is an employee (vs. a volunteer or independent contractor):

  • Does the company control or have the right to control what the worker does and how they do their job?
  • Are the business aspects of the job (how the worker is paid, whether expenses are reimbursed, provision of tools, supplies or equipment, etc.) controlled by the payer or company?
  • Are there written contracts or employee-type benefits involved?
  • Will the relationship continue?
  • Is the work performed a key aspect of the business?

If you have determined that an individual meets the criteria of employee vs. independent contractor or consultant, you will also need to determine whether they are full time or part time as defined by the federal and state regulations that pertain to your business, and whether they are exempt or non-exempt from overtime pay.

2. How does the IRS define Independent Contractor?

The general rule is that an individual is an independent contractor if the payer (or company) 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.” (www.irs.gov)

3. The federal regulations as set forth by the US Internal Revenue Service are just the beginning.

Each state in the US has its own laws, rules and regulations that apply to employee classifications as well as wage and hour laws. Here is a list of US state wage and hour websites and contacts.

Be sure your employees are classified appropriately in order to avoid – or at least survive – an audit from the IRS or your state’s labor and industries department. If you have a question for the IRS relative to a business, you can reach out with tax questions via interactive assistant (or web chat) or contact them at 800-829-4933 Monday through Friday from 7 AM – 7 PM in any of the 4 continental US time zones (Eastern, Central, Mountain or Pacific). You’ll also find forms and publications on the IRS website – so it’s a good site to bookmark for small business owners or business payroll and finance officers.

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