How To Classify Workers and Avoid Crippling IRS Penalties
"Independent Contractor" vs. "Employee"
Overview: It's critical to correctly determine whether the individuals providing services are employees or independent contractors.
The problem can come during an IRS audit of the business
- An employee is generally considered to be anyone who performs services if the business can control what will be done and how it will be done. What matters is that the business has the right to control the details of how the worker's services are performed.
- Independent contractors are normally people in an independent trade, business or profession in which they offer their services to the public. Doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers or auctioneers are generally independent contractors.
Nightmare Scenario: Consider the following possibility. The IRS audits a small business and then determines that its owes over $28,000 in back taxes plus over $10,000 in penalties. They give the business 10 days to pay. They did this because the business had for several years retained a person to perform services and had chosen to treat the person as an independent contractor rather than as an employee (with the business thus being able to avoid paying its one-half share of the worker's FICA taxes and dumping the entire burden for paying those taxes upon the "self-employed" worker). In reaching its determination the IRS disregarded how the business classified the person and, instead, made an independent determination that the person was really an employee.
What the IRS can make you do: If during an audit the IRS determines that a person providing services is really an employee and not an independent contractor there can be serious consequences. They can make the business pay all of the unpaid payroll taxes going back to the date that the worker was first retained. They can also assess penalties. A business with an "employee" must pay one half of the medicare, social security, and unemployment taxes (FICA) owed for that person and must withhold the other half from the employee's paycheck and deposit it with the IRS. Upon reclassification the IRS will also send a notice to "employee" notifying him or her of the reclassification and stating that proof must be submitted that he or she paid taxes based upon being an "employee" and not as an "independent contractor". If this cannot be proven to the satisfaction of the IRS the "employee" may have to also pay the back taxes plus penalties.
For more information
click here for an IRS information page