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IRS Audit: Do You Misclassify Temporary Workers?

IRS Audit: Do You Misclassify Temporary Workers?

By: Melanie Berkowitz, Esq.

May 24, 2010

Small business alert: if you use independent contractors or freelance workers on a day-to-day basis, the Internal Revenue Service (IRS) may be interested in how you pay them — and your company could be the target of an IRS audit.  

In its Spring 2010 newsletter, the IRS announced the start of an “Employment Tax National Research Program” to study how employers are complying with employment tax laws. In simple terms, the IRS plans to audit 6,000 businesses over the next three years to try to uncover so-called “permalancers.” These are temporary workers who are classified and paid as independent contractors despite their working for a single business for years.  

Businesses do not pay payroll or social security taxes for independent contractors and do not have to contribute to health insurance plans for such workers. According to the Government Accountability Office (GAO), misclassification of employees as independent contractors results in over billions of dollars of lost tax revenue every year. 

The Launch of an IRS Audit Program
The IRS and Department of Labor asked the GAO to further investigate the pervasiveness of worker misclassification. Its August 2009 report  found that small businesses are particularly guilty of misclassifying employees as independent contractors — over $64 million in fines were assessed by the IRS’ small business/self employed division in 2008. 

Now the IRS has launched its formal audit program to further address the issue, many experts agree that small businesses will be a particular focus of the agency’s attention.  

While misclassifying a worker as an independent contractor or freelancer is not in itself illegal, the results of such an error could be. Both the tax code and the Department of Labor’s Fair Labor Standards Act have specific standards regarding the correct treatment of independent contractors versus true employees, so a misclassification could lead to the violation of either the tax code or fair pay law.

How Can Small Businesses Respond? 
If your business uses independent contractors or freelance workers, an experienced labor and employment attorney can help you determine if they are classified correctly.  The IRS also provides guidance on the issue. Some employers may also choose to complete IRS form ss-8 which asks the agency for a determination of the correct status of a particular worker. There can be risks associated with the submission of such a form, however, so consulting first with an attorney is always a good idea.

Several pieces of legislation could change the law with respect to how independent contractors are treated for tax and payroll purposes. So far, the Taxpayer Responsibility, Accountability and Consistency Act of 2009 (H.R. 3408) has not progressed beyond the committee stage. Previous versions of a similar law in both the House and Senate have been unsuccessful as well. Given recent IRS interest in the issue, it is possible that the issue could gain momentum in the coming months. Check the Resource Center for updates. 

None of the information provided herein constitutes legal advice on behalf of Monster.