Employee Classification by Karla Hopkins

The likelihood of your business being involved in a worker classification or employment tax audit has increased recently because the IRS is aggressively attempting to reduce the “tax gap,” (the annual shortfall between taxes owed and taxes paid). The IRS entered into agreements with state unemployment agencies in 29 states, including Massachusetts, to share the results of employment tax examinations. This means that if your company is audited by a Massachusetts state agency, the IRS will be notified of the results so that they may come in to review the company's employee-employer relationships. In addition, for the 2008 through 2010 tax years, the IRS plans to examine 6000 randomly selected employers’ Forms 941, Employer’s Quarterly Federal Tax Return. Remember, the IRS can go back three years (and sometimes more) during an examination.

Indeed the focus on classification has intensified such that The IRS launched a program that will enable employers to resolve past worker classification issues by voluntarily reclassifying their workers. The program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit. Full details, including frequently asked questions, are available on the Employment Tax pages of www.IRS.gov , and in Announcement 2011-64

Because the existing worker classification rules are complex and ambiguous, there is uncertainty surrounding their interpretation and application. Understanding the difference between an employee and an independent contractor is very important. If you are an employer, you are required to withhold and contribute a matching amount of FICA and Medicare taxes from your employee’s income. However, if your workers are independent contractors, you are only required to report payments of $600 or more on Form 1099-MISC. Failing to make the right classification could cost you money.

The most often used test for classifying someone as an independent contractor is: Do the workers make substantial financial investments in their own tools, equipment, or a place to work, or undertake some entrepreneurial risks? If so, they are probably independent contractors. However, when you control and direct the workers who perform services for you as to the end result and how it will be accomplished, you are probably involved in an employer-employee relationship.

Unless there is a reasonable basis for treating your employees as independent contractors, failing to withhold income and employment taxes from their wages can result in severe penalties and interest, in addition to the back taxes owed. Your benefit plan may also be in jeopardy if any eligible employees have been misclassified as independent contractors. The misclassification means that these employees have been excluded from plan participation, and thus your retirement plan may lose its tax-favored status.

It is important when you enter into agreements with worker's to define their classification immediately and comply with the current tax laws. Documentation of duties and even having a written contract for services could protect you in the long run against a reclassification of an independent contractor to an employee.

For more information and clarification on employee vs. independent contractor classification visit irs.gov or contact your tax provider for assistance.