IRS Launches Crackdown on Use of Contractor Workers

President Obama's budget for 2011 will bring yet more scrutiny of businesses that use independent contractors to minimize labor costs. This year the IRS will audit 2,000 companies for compliance. If the 2011 budget is approved, the Internal Revenue Service will get the green light to add 100 more enforcement officers over a three-year time period. According to White House projections, Federal coffers will gain $7 billion over a 10-year span as IRS auditors crack down on companies that have misclassified employees as independent contractors and collect employment taxes and penalties from the businesses involved.

The IRS selects companies by statistical sampling, and small businesses are just as likely to be audited as large corporations. The contractor crackdown follows several other policies designed to collect an estimated total of $350 billion, which the President believes is the shortfall created by noncompliance with tax laws. If you think the classification of your employees could be wrong, contact your tax professional as soon as possible. DonÂÂ’t take any chances. The tax code is vague, the IRS' assessments are hard to predict and penalties accrue daily.

Workers in the United States are usually employees or self-employed workers - otherwise called contract workers. The contractor tax issue is not new; neither are the problems that occur as companies try to classify their workers correctly. Problems arise because there is no clear, universal definition of what constitutes a contract worker. The IRS' own reclassification frequently is made years after a worker has been hired. The determination is made based on how much control the individual has over the scope of the job and the worker's exposure to costs and risk. For example, if a worker is required to come to the employer's place of business to work and be present for specific hours on specific days, he or she would most likely be classified as a payroll employee. High-tech consultants, home healthcare workers and construction workers are among those who are misclassified the most. If the IRS decides that a contract worker should have been classified as an employee, it could impose significant back taxes, interest and other penalties. These can be substantial and are owed to the IRS even if the contract workers paid their taxes in full.

The punitive nature of penalties has caused many employers to convert contract positions into payroll employees - even though contractor labor might provide savings of up to 30 percent on labor costs. Companies do not pay Social Security, Medicare, sick leave, etc. for contract employees.

The technology sector, where the use of independent, self-employed contractors is especially common, has seen a wholesale shift from contractors to employees. Unlike other sectors where contract workers often would prefer the health and other benefits of payroll employment, technology contractors were willing to forgo employer-provided benefits for the chance to grow their own business and make money. These opportunities began to dry up a decade ago when industry leaders were found guilty of misclassification and hit with big fines. Microsoft paid $6 million in employment back taxes and penalties in 2000 when an IRS team discovered 12,300 cases of misclassification.

If contract workers are a part of your workforce, don't gamble on avoiding an IRS review. Get help now to make sure you stay on the right side of the tax laws.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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