Monday and Tuesday this week, I attended a corporate tax update class in Ocean City, Maryland. While I was out of the office, my beloved Jen Aniston stopped by. On Facebook, I posted a picture that proves she was actually there. She signed her picture and even wrote “I miss you, XOXO.” For those of you, who only understand English, “XOXO” means hugs and kisses. We are a really affectionate couple. Silly me – I forgot to tell her I would be in Ocean City. She could have joined me there. Paul would have had to give up the back bedroom in his condo, where we slept during the conference. Paul slept in the back bedroom and I got the pull out sofa. We didn't sleep together in the back bedroom to be perfectly clear. More correctly, I should say we slept AT the conference.
If someone invites you to a corporate tax update conference, punch him in the face. Sitting through a corporate tax update class is like learning about new methods of waterboarding – minus the celebrity appearance by Dick Cheney.
In my first installment of “Misclassify Your Workers” I covered the basics of determining whether your workers are truly independent contractors or employees. I also showed an example of a clearly misclassified worker and wrote about an IRS program administered in cooperation with state unemployment tax offices. If you missed part I, please read it first. In this installment, I will write about one of our clients, who did everything perfectly and had a great audit outcome. I will also explain exactly what they did correctly and why it worked so well. Finally, I will tell you about an IRS amnesty program if you have been misclassifying your workers.
In part I, I wrote about how I found out about the joint IRS / unemployment tax office audit program. The client, who was audited, requested that I attend the audit, and it was my pleasure. They were as absolutely well prepared as they could possibly be. Before the audit, I told them they were probably not being audited by the state unemployment tax office to see if they had incorrectly completed their quarterly unemployment tax forms. They were being audited to determine if they were misclassifying employees as independent contractors. Instead of spending a lot of time reviewing their payroll records, I asked them to prepare a file for each independent contractor for whom they had issued 1099-MISC forms. They used a payroll service. So I was certain the unemployment tax forms were in order.
In the file, I asked them to assemble a number of documents for each independent contractor. First, they retrieved copies of the W-9 forms they had required of each contractor. A W-9 form is given by a company to its independent contractors. The contractor completes the form, giving his / her federal tax ID number, business name, and type of entity.
Next, in each file they placed a copy of the contractor's proof of liability insurance. Yes, my client requires contractors to have liability insurance policies. Why? A contractors liability insurance is a level of assurance that my client won't suffer losses if the contractor destroys a customer's property. But that isn't the reason for the purposes of our audit. A liability insurance policy supports the concept that the contractor is really in business – not an employee. Do your employees have liability insurance? Of course not. A workers compensation policy is even better. However, in most states, very small companies aren't required to have them.
Third, my client put copies of invoices submitted by each contractor in the files. Yes, the contractors invoice them to get paid. Do employees submit invoices to get paid? Of course not. As you can see, we are building a strong case that each contractor is a separate business.
When the auditor visited, all of the files were in order and presented to him. The audit result was perfect. No contractors were reclassified as employees. My client had prepared perfectly. This audit was won before the auditor set foot in the office. There are some other items I think would be great to further convince an auditor that your contractors are properly classified.
First, to be separate legitimate businesses, your contractors should really have business licenses. In Virginia, business licenses are issued by the counties. If I were an auditor, I would place great weight on this. In my experience, however, they place next to no emphasis on business licenses. They place far more emphasis on another factor, probably unintentionally.
Independent contractors should have fictional names. In my bedpan cleaning example from part I, the employer might have entirely escaped scrutiny if the 1099 form had been issued in a name like “Bedpan Technologies, LLC” instead of “Frank Stitely.” The 1099 issued to the LLC would have a federal employer identification number on it. One issued directly to a person normally has a Social Security number on it. Auditors look at Social Security numbers on 1099 forms the way the Army's predator drones look at terrorists. Find and destroy.
I would suggest going one step further with your contractors. Help them organize their limited liability companies. I don't mean paying the $100 fee (in Virginia). Just forcefully suggest it as a requirement for having you as a customer.
As you can see, surviving an independent contractor audit can be easy if you gather the proper documentation. However, what can you do if you suspect there is no way you could survive an audit? The IRS is offering an amnesty program. There are a number of requirements to participate. In short, you can't already be in the process of an audit. That's too late. If you agree to fess up and become a fine upstanding employer in the future, you can get away with paying just 10% of the payroll taxes for which you would be liable on audit. And you only have to pay for one year. You also have to agree to treat all of the workers in question, and similar workers in the future, as employees. This is a great deal. If your business is grossly non-compliant with the independent contractor classification rules, run to your nearest IRS office and confess. Confession is not only good for the soul, it might save you a lot of money in an audit.
As always, if you want non-snarky tax and accounting advice, please visit www.skcpas.com. Thanks for reading!!
Frank
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