This past weekend Laura and I visited my oldest daughter at James Madison University. We went to watch a football game on Saturday afternoon and just catch up with Meg. Early on Saturday afternoon, Meg and her roommates held a pregame cookout. At the cookout, I met Meg's BFFRN. For those of you not fluent in text speak, that means boyfriend for right now. I liked him a lot. He is a Capitals fan, so liking him was easy. After a couple of beers and a little sports conversation, I unloaded my pistol and put it away.
The next morning I called Meg from our hotel to tell her we were leaving to pick her up for a late breakfast. We weren't out the door yet. So that gave her about half an hour to get ready. When we pulled up to her apartment, we saw her BFFRN walking out of the apartment. In my younger days, half an hour was plenty of warning to vacate my girlfriend's apartment when her parents were on the way. Fifteen minutes warning was even enough for me to get a shower first. He had a sheepish look on his face when we greeted him. We told him that we were young once. We weren't going to hassle him. I did reload the pistol, however. I hope his life insurance is paid.
I apologize in advance for this being a two part piece, but this is an urgent topic for business owners. Please indulge me this time. In this first part, I will tell you about a new audit program the IRS is using to catch employers, who are misclassifying employees as independent contractors. I will talk a little about rules for classifying workers as employees or independent contractors. Then I will show where a company has gone horribly wrong in their policy. In the second installment, I will show you how to avoid problems in an independent contractor audit and talk about a client who survived an audit by doing everything right.
Two months ago, I got a message from a client telling me that the state unemployment tax people had scheduled an audit of their payroll. This type of audit is usually to determine if you have paid all of the unemployment tax payments that you owe. I have helped clients through a lot of these over the years. The client wanted me to attend the audit and I agreed.
During the course of the audit, I struck up a conversation with the auditor. I usually try to develop a friendly relationship with auditors. If I can get an auditor to view my client and me as good people, we may be able to get the benefit of the doubt if an issue arises. During the course of the conversation, he told me that this audit was part of a IRS program to identify employees misclassified as independent contractors. To make this clear, this was a state unemployment tax audit that was part of a joint program sponsored by the IRS. At this point, I knew the auditor didn't really care about auditing payroll. He was interested in auditing my client's 1099 forms. He was looking to reclassify independent contractors as employees. Since that first audit, I have had a couple more clients audited under this program. The first audit was in Maryland, but the subsequent ones were in Virginia. This is a national program.
To determine if you have misclassified an worker as an independent contractor, the IRS considers three factors: degree of behavioral control, degree of financial control, and relationship. In short, if you exercise significant control over a worker, that worker will likely be considered an employee by the IRS. If you have classified that worker as an independent contractor, the IRS will assess the taxes that you should have paid if you had treated the worker as an employee – plus interest and penalties. Rather than go into a long discussion of the three factors, I will show an example of a misclassified worker.
Let's say you own a nursing home, and you need to hire someone to clean bedpans. You hire some miscreant, named Frank Stitely, just to throw out a name. You don't really want to pay the employer share of Social Security, Medicare, and unemployment taxes for him. So you give Frank a contract that explicitly states that he will be treated as an independent contractor, not an employee. In addition, you hand him a W-9 form to complete. Frank dutifully signs the contract and completes the W-9 form using his Social Security number as his taxpayer identification number. Some days cleaning bedpans seems preferable to preparing tax returns.
In the contract, you agree to pay Frank twenty dollars per hour. You tell him that the going rate for bedpan duty is $15 per hour, but you are paying him more since he is an independent contractor to cover his taxes. To perform his duties, Frank has to come to your facility from 8:30 A.M. To 5 P.M. just like your other employees. He will use your bedpans, and you agree to pay him every two weeks just like everybody else. He also has to submit the same timesheet everyone else uses.
Frank is happy processing poo until he goes to S&K to get his income tax returns prepared. There, a very knowledgeable tax preparer tells him that he is paying way more in taxes than he would if you had treated him as an employee. The tax preparer goes further and has Frank complete an SS-8 form. An SS-8 form is a form that can be submitted to the IRS to ask them to determine if a worker should be classified as an employee or an independent contractor. Frank is no longer a happy little bedpan jockey. He mails the form to the IRS, and a few months later you get a cryptic letter from the IRS telling you that a nice man in a boring blue suit will be visiting your facility to determine if you are misclassifying employees as independent contractors.
How do you think you will fare in this audit? Let's evaluate Frank's situation against the three factors the IRS uses to determine the correct status. First, what is the degree of behavioral control you exercise over Frank? He works in your facility, using your tools (bedpans), and is required to follow all of the procedures your employees follow. Strike one.
What is the degree of financial control you exercise over Frank? He gets paid by the hour just like your other employees. He has no risk of financial loss. In other words, he incurs no business expenses. You pay for all of those. Strike two.
What is your relationship with Frank? You had him sign a contract that stated that he understood that he would be treated as an independent contractor. You also had him complete a W-9 form and issued a 1099-MISC form to him after end of the year. All of that is in your favor. However, Frank does not have a business license and does not carry a liability insurance policy. He only works for you and isn't really in business for himself. Strike three and you are out. Taxes,penalties, and interest are in your future.
Unfortunately, I see a lot of situations like Frank's. The more a worker looks like an employee, the more likely he is to be reclassified as one by the IRS. In the next installment, I will show you some ways to make certain you can survive an independent contractor audit.
For more informative tax and accounting information, please visit the main S&K web site, www.skcpas.com. Thanks for reading and go Redskins! Beat those dog hating Eagles.
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