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IRS: Vast Majority of Independent Contractors are Mislabeled

Forbes reports that the IRS is taking a much closer look at workers labeled as “independent contractors,” and that could mean potential trouble for employers.

When employers pay independent contractors, there’s no income tax withholding, no employment taxes – it’s the responsibility of the worker to pay taxes. Even assuming that the “contractor” files a tax return, the IRS won’t collect as much and will get it much later. The fact of the matter is, wage withholding is better for the IRS because it puts the money in their hands earlier.

It turns out State tax authorities are looking closer at independent contractors, too. So are insurance companies, unemployment departments and Worker’s Compensation carriers. The classification also matters for pension and benefit laws. And under the Affordable Care Act, many rules hinge on who are actually your employees, because independent contractors aren’t covered.

If you’re in business and guess wrong, the liability for past years can be crushing. And the IRS Inspector General has just issued a report saying that despite IRS efforts, employers are still getting it wrong.

According to a report from the IRS Inspector General for Tax Administration, millions of workers are misclassified as independent contractors instead of employees. These employers are dramatically underpaying employment taxes.

So how do you determine who are employees and who are independent contractors? The employer or the worker can ask for an IRS ruling. A streamlined ruling form is available (IRS Form SS-8) for any worker or employer to fill out and submit. The good news is that, unlike most other rulings from the IRS where there’s a fee, this one is free.

According to Forbes, most forms are submitted by workers, and the vast majority – 90% – produce an IRS ruling that the worker is an employee, not an independent contractor. Of course, it’s the nature of the IRS to come out in favor of the withholding and employment tax. but nonetheless, it shows that the vast majority of independent contractors are most likely mislabeled.

The IRS does offer a Voluntary Compliance Settlement Program (VCSP). To be eligible, an employer must:
• Currently be treating the workers as independent contractors;
• Consistently have treated the workers as independent contractors in the past, including filing 1099 forms
• Not be under IRS audit on payroll tax issues
• Not be under audit by the Department of Labor or state agencies for the classification of these workers
• Not be contesting the classification of the workers in court

If you’re an employer, you can apply for amnesty by filing Form 8592, at least 60 days before you want to start treating workers as employees. There are no penalties and no interest, and employers will not be audited on payroll taxes related to these workers for prior years.

Determining who’s an employee and who isn’t is a real minefield. It is very fact-intensive, and small nuances can spell the difference between success and failure. And the stakes are getting bigger and bigger.

If you’d like to continue the conversation about this and other Workers’ Compensation issues, I look forward to hearing from you.

Mark O'Bryan

Vice President | Los Osos