Federal and State Income Tax Authorities Scrutinize Employee vs. Independent Contractor Classifications

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According to press reports, the Internal Revenue Service (IRS) and some states are taking a proactive and less flexible approach to how employers are classifying workers as employees or independent contractors. This new scrutiny of possible worker misclassification is driven by the need to collect more revenues to address budget deficits.

The IRS’s initiative is called the National Research Project (NRP) audit program. It will audit 2,000 randomly selected companies during each of the next three years, starting February 2010. Small and large companies, for-profit and non-profit companies, and public and private companies will be included in the study. The IRS will be looking at those companies that submitted Form 941 as well as other company records. According to the IRS, the purpose of the program is to obtain data to serve as benchmarks for a new audio selection policy. The IRS wants to learn more about worker classification, fringe benefits, non-filers and executive compensation. Another 60,000 employers can also expect regular and annual employment tax audits.

Many states are legislating new laws to examine more closely the employer/employee relationship in terms of wages and taxes to be paid. New Jersey can suspend (either temporarily or permanently) any state business licenses of an employer in violation of the state’s new statues. Maryland and Delaware have passed new legislation specifically as it relates to the construction and landscaping industries. Pennsylvania is in the process of enacting a similar law for those industries. Various fines can be assessed for employers who fail to comply.

Many (if not most) employers are familiar with the common law and the IRS and Social Security Administration’s 20-factor method to define an employee versus an independent contractor. The 20-factor method and other IRS materials on this subject are meant to serve as guidelines for employers, accountants and auditors. Interpretation of the findings of this method depends on the circumstances and the occupations being assessed. In simplest terms, a worker is considered an employee if his or her employer controls and supervises the employee’s goals and the methods the employee uses to achieve expected results. An independent contractor must only follow the directions of those contracting for his or her services in terms of the goals to be achieved. Unlike employees, independent contractors are free to choose whatever methods work best for them to provide the services promised.

Any company that utilizes the services of independent contractors would be best served to evaluate these relationships, so they don’t become targets of these new laws and their penalties.

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