Are your employees and contractors in the proper class code?

Should your clients' independent contractors really be employees? The IRS is stepping up worker reclassification efforts.
September 24, 2012
By Jim Buttonow, CPA/CITP

The IRS, U.S. Department of Labor, and state governments have a big stake in correctly classifying workers. Improper treatment of workers as independent contractors costs the government tax revenue, in the form of lost withholding, unemployment, workers’ compensation, and Social Security and Medicare taxes. This opportunity for reclaiming revenue has led to renewed compliance efforts.
How big is the problem?
Even with the interest in proper classification, it is not clear how many workers are misclassified. According to U.S. Bureau of Labor Statistics, contractors made up 7.4% of all workers in 2005—equating to 10.3 million workers. With the recent economic stress on small businesses, chances are that the use of contractors has increased significantly since 2005. A 2011 MBO Partners study found that about 16 million workers were classified as independent contractors and predicted an even greater use of independent contractors in the next 10 years. After all, independent contractors are about 30% cheaper than employees and come without many burdensome employment rules—compelling incentives for businesses.
A 2000 Department of Labor (DOL) study revealed that 10% to 30% of all employers misclassify workers. In 2008, the IRS found that even when workers and employers asked the IRS for proper classification, only 3% of the workers in question were independent contractors. However, the IRS does not have current, definitive numbers. The last definitive study on the issue was conducted in 1984 and concluded that 15% of employers misclassified 3.4 million workers as independent contractors.
The IRS is stepping up worker reclassification efforts, which represent a substantial revenue opportunity. In fact, a 2009 U.S. Government Accountability Office report stated that 71% of IRS worker misclassification examinations result in changes to worker status. The IRS is currently finalizing a three-year National Research Program initiative that included random audits of 6,600 employers. The study will quantify levels of worker misclassification, and the IRS and many states expect the study to reveal significant noncompliance.
The government’s stake in correctly classifying workers
The IRS knows that it is easier to keep employees compliant than independent contractors. The latest IRS tax gap study shows that Form W-2 employees misreport only 1% of their income, while, on average, independent contractors misreport 8% of their income. For the IRS, employee status means more automated, less expensive post-filing compliance activity, such as underreporter notices.
Employee status is even more important in light of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, which mandates that employers with at least 50 full-time employees provide health care insurance or pay a stiff penalty. The mandate goes into effect in 2014, but employers may already be trying to reduce payrolls to avoid new taxes and requirements under PPACA. One way employers may reduce payrolls is by treating workers as independent contractors, rather than employees.
Worker reclassification has also been of interest to the Obama administration. In 2011, the DOL confirmed its commitment to use audit and enforcement resources to address the growing problem of employee misclassification. There is also a coordinated effort among the IRS, DOL, and many states to share audit findings and pool resources to address worker classification. At the 2012 IRS Tax Forum, held from July 31 to Aug. 2 in Las Vegas, IRS officials said that the IRS is coordinating employment tax examination findings with 37 states.
Settlement programs
Despite the problem, the IRS does not have a clear, bright-line test to determine the proper classification of workers. Traditionally, the IRS has used the 20 common law factors found in Rev. Rul. 87-41 to test whether a worker is an independent contractor or an employee. Over the years, the IRS has tried to simplify determinations without much success. To complicate matters further, since 1978, IRS worker reclassification efforts have been hampered by defenses under Section 530 of the Revenue Act of 1978, which provided employers with safe harbors, such as reliance on a prior IRS audit or a long-standing industry practice.
As a result, reclassification audits often led to long disputes in IRS appeals offices. To combat the enforcement stalemates, in 1996, the IRS instituted an early resolution program that could be used to settle audit disputes. The Classification Settlement Program (CSP) allowed for prospective treatment of workers as employees but limited the taxes owed due to reclassification.
In 2011, the IRS began the Voluntary Compliance Settlement Program (VCSP), which allows an employer to seek prospective treatment for workers and pay even less than under the CSP arrangement, but the program is purely voluntary. It is not available for taxpayers in an employment tax audit conducted by the IRS, DOL, or state agencies. Since the program started, the IRS has received only 625 applications, according to officials at the 2012 Carolinas Tax Forum, held Aug. 8–10 in Charlotte, N.C.
Practitioners may be concerned about legal ramifications for their clients if they voluntarily supply information involving potential noncompliance. However, the IRS states that the VCSP offers audit amnesty. An IRS official at the 2012 IRS Tax Forum explained further that the IRS will not share VCSP applications with any other federal or state agencies and that employee treatment is prospective and does not imply that the contractor was an employee in the past.
What you can do for your clients
As federal and state agencies continue to address worker misclassification, there are three proactive reviews you can conduct to identify risks and reduce exposure for your clients:
Review Form 1099 recipients for proper classification. Investigate who controls the worker. If your client is in control, based on your objective analysis of the 20 common law factors, then your client should be treating the worker as an employee. Use Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to guide your fact gathering of any workers in question. Also, look for inconsistencies in your client’s workforce, including similar workers with different classifications. If your client has to reclassify a worker or a group of workers, offering the VCSP as an option can soften the news.
Review workers who received Form W-2 in the past but are now treated as contractors. These workers are of particular concern because they do not qualify for the VCSP. Your client must have a clear, documented explanation for the change in treatment. Also, review workers who receive Forms 1099 and W-2 in the same year.
Review your client’s vendor list, check register, and accounts payable to determine whether your client filed a Form 1099 or W-2. Here you may find real exposure for your client. If your client fails to file the required information statements altogether and to withhold required taxes, your client can become fully liable for the taxes associated with unreported payments and will be subject to failure to file penalties. The client will also be subject to penalties for failing to provide a copy of the return to the payee. Advise your client to file any delinquent Forms 1099 or W-2. If the IRS finds that your client willfully failed to file the information returns, higher penalties apply.
It is a good time to conduct a workforce review for your clients. Even if the IRS or other agencies take issue with your assessment, the analysis can help demonstrate that any misclassifications were not willful and that your client is taking steps to comply.

Hours of Service

The hours-of-service rules set to take effect next year for truck drivers will add a significant cost to the trucking industry without providing much of a benefit, American Trucking Associations said Tuesday in a court filing.
It is the first brief ATA has filed in its lawsuit, first filed in February, challenging the hours-of-service rule that will put restrictions on the 34-hour restart that drivers can use to reset the weekly driving maximum.
The Federal Motor Carrier Safety Administration “claims that restart restrictions and the off-duty break requirement are justified by the cost-benefit analysis in FMCSA’s regulatory impact analysis,” ATA wrote. “That ‘analysis,’ however, is a sham.”
Starting in July, the restart period must include two spans from 1 a.m. to 5 a.m., and drivers can only use it once per week. Additionally, drivers must take a 30-minute break before driving more than 8 hours.
“FMCSA stacked the deck in favor of its preferred outcome by basing its cost-benefit calculations on a host of transparently unjustifiable assumptions [and] therefore cannot justify the 2011 final rule on the ground that it has net benefits,” ATA wrote to the U.S. Court of Appeals for the District of Columbia Circuit.

Check your federal withholding, especially if you've married, had children, bought a home, earned investment income, or made capital gains profit in 2012. Conventional wisdom says withhold just enough tax to meet your tax liability. Although withholding too much means a refund, you're also giving Uncle Sam an interest-free loan. Withhold too little and you'll owe taxes plus possible penalties and interest. You can change withholding anytime of year by submitting a revised Form W-4 to your employer.

Obamacare

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The Court concluded that the federal government did not have the power to require individuals to buy health insurance, but it did have the power to impose a penalty on those who failed to do so. The Code Sec. 5000A(a) individual mandate that required persons to carry minimum essential health coverage for themselves and their dependents exceeded the federal government's powers under the Commerce Clause (Article I, §8, clause 3) because it would require inactive individuals to become active in interstate commerce. In addition, regardless of how integral the mandate was to the health care reform law as a whole, the Necessary and Proper Clause (Article I, §8, clause 18) did not provide independent authority for it.
However, the shared responsibility payment that Code Sec. 5000A(b) imposed for violating the mandate was a constitutional exercise of the federal government's Taxing Power under Article I, §8, clause 1. The Taxing Power is broader than the Commerce Power, because it gives the federal government a lesser amount of control over individual conduct, limited to financial coercion but not extending to criminal punishments. Although it was identified as a penalty, the payment is actually a tax because it was not intended to be punitive: its amount is relatively small, it applies even if the taxpayer does not knowingly violate the mandate, and the IRS has the sole authority to assess and collect it. The fact that the payment was intended to affect individual conduct does not preclude it from being a tax, especially since there are no criminal penalties for failing to carry insurance. In addition, the payment does not violate the prohibition on direct or capitation taxes (Article I, §9, clause 4) because it is triggered by specific circumstances, and is not imposed on every person or on the ownership of land or personal property.
Although the penalty actually functions as a tax, it is not subject to the Anti-Injunction Act under Code Sec. 7421(a) . Since Congress characterized the payment as a penalty, rather than a tax, it was clear that Congress did not intend for the Anti-Injunction Act to apply. This intention is not affected by the fact that the penalty is a tax for purposes of determining whether Congress had the power to impose it. The issue of the Anti-Injunction Act was a matter of statutory interpretation, so the language Congress used determined the outcome. However, the constitutional issue of whether Congress has the power to impose the tax was determined by the way the penalty actually operated, rather than what it was called.
Finally, the federal government could not withhold existing federal Medicaid funding in order to force a state to extend Medicaid coverage to individuals whose income was less than 133% of the applicable federal poverty levels. The extension so exceeded the original parameters of the Medicaid program that states could not be considered to have voluntarily agreed to it at the time they agreed to participate in the Medicaid program. However, this provision could simply be severed from the remainder of PPACA."

The 2012 Highway Bill did not pass!

Webinar Available from the IRS

U.S. Department Of Homeland Security Offers Free Webinars
The U.S. Department of Homeland Security is offering free webinars throughout the month of June on E-Verify, Self-Check, and Form I-9. The following seminars are being offered:

• E-Verify Overview. Learn how this free service works, how to enroll, employer responsibilities, program highlights, and see a demonstration.
• E-Verify for Federal Contractors. For Federal contractors that have been or may be awarded a Federal contract with the FAR E-Verify Clause.
• E-Verify for Existing Users. A detailed review of E-Verify specifically for existing users. Topics include Form I-9, user roles, case alerts, how to handle a Tentative Nonconfirmation and common user mistakes.
• An overview of "Self Check". A voluntary, fast, free and simple service that allows individuals to check their own employment eligibility.
• Form I-9. Get an overview of the Form I-9 process, including step by step instructions on how to complete each section, retention and storage.
• CNMI. An overview to employers and workers residing in the Commonwealth of the Northern Mariana Islands (CNMI) about Form I-9.

The complete schedule of free live webinars is available at www.dhs.gov/E-Verify (click on "Take a Free Webinar.")