IRS Steps Up Audits of Businesses’ Use of Contractors

Businesses are increasingly relying on independent contractors to provide needed services. While using independent contractors can provide a business with significant benefits, if a worker is improperly classified as an independent contractor rather than an employee, the business can be exposed to significant liability. The IRS is in the midst of a three-year program to audit businesses, directed in part towards examining the classification of workers as independent contractors. The President’s proposed 2011 budget also sought increased funding for enforcement, including specifically for employee misclassification.

Businesses often prefer to use independent contractors for a variety of reasons, including not being responsible for paying payroll taxes, unemployment insurance, and worker’s compensation insurance. However, if the IRS finds that a worker was wrongly classified as an independent contractor but was actually an employee, the business can face liability for back taxes and penalties. In addition to an IRS audit, a company’s workers (including disgruntled former workers) can contact the IRS about an alleged misclassification.

Consequently, businesses need to take care to properly classify workers and to maintain proper documentation. The IRS looks at a variety of factors in determining whether a worker is an employee. These factors fall into three categories: behavioral control, financial control, and the relationship of the parties. While not dispositive, every business should have a written independent contractor agreement with each independent contractor that it hires. For assistance with determining whether a worker is an employee or independent contractor, businesses should seek counsel. In some circumstances, it may be advisable to obtain a determination from the IRS by filing Form SS-8.