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Proper classification of workers as employees or nonemployee workers is a tax issue that continues to attract the attention of IRS examiners.
Businesses are required to withhold payroll taxes, including income, Social Security and Medicare taxes from compensation paid to employees. Generally, no withholding is required for payments to independent contractors.
Businesses may be required to pay workers' compensation, unemployment taxes, health, retirement and other fringe benefits to or on behalf of employees. Independent contractors generally receive no such benefits from the companies to which they provide services.
Employers and employees split the cost of Social Security and Medicare taxes. Independent contractors pay the entire cost of these programs through self-employment tax.
Employers who incorrectly classify workers as nonemployees and fail to withhold payroll taxes can be held responsible for up to double the amount if the workers fail to pay the required taxes themselves. In some cases, individuals responsible for the withholding can be held personally liable for the payment, even if the responsible person is not an owner of the business.
Last year, the Treasury Inspector General for Tax Administration recommended additional efforts by the IRS to examine worker classification.
Earlier this year, in a webcast sponsored by the American Law Institute-American Bar Association, an IRS official revealed that the IRS is completing the first year of a three-year National Research Program payroll audit by randomly selecting 2,000 returns from all types of employers.
Based on studies done more than a decade ago, the IRS estimates that employment tax underreporting accounts for about $54 billion of the so-called "tax gap" – the difference between what taxpayers owe and what they actually pay. The IRS estimates the total tax gap at $345 billion.
Last year, the Obama administration asked Congress to authorize the IRS to issue guidance about proper worker classification and implement other recommendations of the Treasury Inspector General. Since Congress did not act in 2010, the White House may renew its request in 2011.
Businesses and workers can request a determination letter from the IRS regarding a worker"s employment status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
While the IRS looks at a number of factors to determine worker classification, the facts that provide evidence of the degree of control exercised by an employer and degree of independence exercised by a nonemployee contractor generally fall into three categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2. Financial: Are the business aspects of the worker's job controlled by the payer? Questions like how the worker is paid, whether expenses incurred by the worker are reimbursed and who provides the tools and supplies used by the worker influence this determination.
3. Type of Relationship: Are there written contracts governing the working relationship? Does the worker receive employee-type benefits (e.g., retirement plan, insurance, vacation, etc.)? Is it a long-term working relationship?
Because workers treated as employees tend to be more compliant in meeting their tax obligations, businesses and workers should expect increased scrutiny of independent contractor arrangements from IRS examiners.
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