Employment Tax Audits Are Coming

All signs point to increased enforcement of employment tax laws, particularly regarding classification of workers as employees vs. independent contractors.  In July, the Department of Labor issued an Administrator’s Interpretation concluding that most workers are employees under the Fair Labor Standards Act.  In August, the Internal Revenue Service issued a fact sheet reminding employers to correctly classify workers for federal employment tax purposes.   In July, President Obama remarked, while announcing a proposed rule to increase the automatic exemption for overtime pay, that some employers are purposely misclassifying workers as exempt in order to avoid minimum wage requirements.  Employers that misclassify workers as independent contractors may do so to gain a competitive advantage by not only denying workers minimum wage, but also denying workers benefits such as overtime pay, family and medical leave and unemployment insurance.  

David Weil of the DOL says in the memo that workers who are economically dependent on the business of the employer meet the definition of employees according to the Fair Labor Standards Act.  The DOL looks to a number of factors, which have been developed by the courts over time, including:

Factors to Determine if a Worker is Economically Dependent on the Business of the Employer

  • the extent to which the work performed is an integral part of the employer's business,
  • the worker's opportunity for profit or loss depending on his or her managerial skill,
  • the extent of the relative investments of the employer and the worker,
  • whether the work performed requires special skills and initiative,
  • the permanency of the relationship, and
  • the degree of control exercised or retained by the employer.

The IRS looks to similar criteria when making a determination of employee vs. independent contractor status.   They refer to a 20-factor test that dates back a couple of decades.  Lately, the IRS has been instructing their agents to look at the overall situation, including the relationship of the worker to the business, his level of control over that work and the degree of independence with which he or she can work.  The IRS has grouped the 20 factors into those three broad categories similar to what the DOL considers:

Three Categories Considered by the IRS for the Determination of Employee vs. Independent Contractor Status

  • behavioral control
  • financial control
  • type of relationship between the worker and the employer

It is important to keep in mind that any written contracts will probably not carry as much weight in the determination as the actual facts and circumstances and how they correlate to the above factors.  

If the IRS determines that an employer misclassified workers as independent contractors, it can assess employment taxes, including the employer’s share of FICA taxes and unemployment taxes, for three years on all of those workers.  With penalties and interest, this can add up to a significant amount.  The IRS has instituted a Voluntary Classification Settlement Program that allows employers some degree of relief from employment taxes if they enter into an agreement with the IRS and reclassify their workers as employees going forward. 

To be proactive, employers should conduct a review of their relationships with all independent contractors in conjunction with the above factors.  A careful analysis of all the facts, paying particular attention to those that indicate behavioral or financial control, should be made to determine the proper classification of workers.

Contact us with questions regarding employment tax laws and the classification of workers as employees vs. independent contractors and visit the Schneider Downs tax blog for similar articles.

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