Practice Areas

IRS Targets Companies Using Independent Contractors

February 2010

By: Nancy Joerg, Esq.

For several decades, the independent contractor issue has been a cloud of anxiety hanging over the heads of the companies who use them. These companies worry - often with good reason - that they will be audited by the IRS and other government agencies.

Now, recent threatening announcements made by the IRS have created shockwaves across the United States. Per its own announcements to the public, the IRS is going on the warpath against companies using independent contractors (workers who are not classified as employees), unleashing 6,000 random audits starting in February 2010!

The IRS has stated that these audits will focus on five primary employment tax issues: worker classification (independent contractor versus employee), fringe benefits, reimbursed expenses, officer compensation and non-filers.

The IRS has announced that the audits in 2010 will likely focus on employment tax returns for the calendar years 2007 and 2008. (Of course, the IRS can expand the scope of the audit either backwards or forwards into other open employment tax years and into other tax issues).

In an intimidating observation, the IRS has remarked that there is very little that companies can do to avoid being targeted under this aggressive new audit initiative because the companies will be selected at random.

In an interview on September 18, 2009, IRS Chief of Employment Tax Operations John Tuzynski stated that the IRS will spend three years on the audits randomly selecting large and small companies across many different industries. (This announced audit initiative marks the first comprehensive examination of employment tax issues by the IRS since 1984.)

According to a report by the Government Accountability Office released in August 2009, only 3% of determinations submitted to the IRS showed workers to be true independent contractors. The IRS assessed over $64 million in taxes and penalties for worker misclassification in 2008. Improper classification, as viewed by the government, cheats the government out of employment tax revenue and the worker out of labor protection. The IRS point of view is that workers who are improperly classified as independent contractors can be unfairly denied health benefits, overtime pay and unemployment insurance granted to employees.

The IRS concludes there are numerous cases of misclassification that could result in increased money for the government and more benefits for workers, all of which will ultimately cost employers more money in the form of higher tax liabilities, reporting requirements and increased benefit expenses.

The announced IRS crackdown on independent contractor use is frightening to employers. The IRS has indicated these audits will be conducted by approximately 200 to 300 of its most experienced agents who will undergo further specialized training for their role in this employment tax audit initiative. These audits will very likely involve a line-by-line review of the company's employment tax returns. Businesses should review their compliance before these exams begin. Those with potential issues and concerns regarding the strength of their independent contractor relationships can beef things up in advance of these audits.

All companies who use independent contractors should take steps to:

1) Evaluate all independent contractor agreements with an experienced attorney.

2) Review your websites to make sure that, in your enthusiasm to advertise your services to prospective customers, you are not undermining your independent contractor relationship.

3) Collect key pieces of proof to show that the independent contractor is self employed.

4) Understand IRS Section 530 safe haven protection. (Section 530 is liberally construed in favor of the taxpayer, so it pays to be both aggressive and creative under this law.)

5) Know the IRS "tests" for your type of independent contractors. Not every type of independent contractor is treated the same.

If your company is selected for an IRS audit, do not talk to an IRS agent or auditor without careful legal guidance. Just a few careless words can wreck the company's legal position as to independent contractor classification (especially for Section 530 safe haven defense). Establish a precise chain of command for responding to audit requests and other IRS communications. Control the IRS audit process by requesting additional time to respond to IRS requests for information, and narrow the scope of information requested where possible.

Now is the time to do a thorough "self audit"! Contact Nancy E. Joerg to set one up.

Questions? Please contact WS Shareholder and Senior Attorney Nancy E. Joerg at 630-377-1554 or najoerg@wesselssherman.com.