What Auditors Look for: Independent Contractor vs Employee

If your business has been selected for audit, the auditor will hone in on the issue of independent contractor versus employee. According to the Audit Techniques Guide on the IRS website, agents are told to focus on this area of the tax form because they could generate additional revenue from payroll taxes, penalties, and interest by reclassifying independent contractors to employees.

So what are they looking for? Here’s something right out of the manual:

1. A former employee coming back to a company as an independent consultant with minimal break in service.
2. The continued use of the same strategic alliances.

The IRS is aware that in the last decade there has been a significant downsizing of businesses. Employers have been shifting full-time employees to independent contractors in order to reduce their payroll and fringe benefit costs. The IRS frowns upon this practice.

IRS agents are looking for businesses that cannot fulfill their clients’ objectives on their own and hire an independent contractor to help. This often leads to an employer-employee relationship and therefore a potential misclassification.

There is no clear definition of full time employee and contractor, which adds to the confusion. The auditor will rely on Section 530 of the IRS tax code, which can be somewhat vague, forcing the agent to weigh the facts and circumstances in each case to determine the appropriate classification.

“The IRS and states have been cracking down on misclassification of workers,” said Jennifer Berry, a senior associate  labor and employment lawyer from the firm Dorsey & Whitney, LLP in Seattle. “There’s no single factor to test whether someone is an independent contractor but typically contractors are hired for discrete projects and they control the when, where, and how to do the work.”

When auditors first look at this issue, they will ask to see copies of all Forms 1099 issued to your independent contractors. If you have failed to issue 1099s, you can be subject to a penalty and disallowance of the deduction. This can usually be remedied by issuing the required forms.  But look out: Some independent contractors may not have declared their income from you because they did not receive a 1099. This is not a good excuse, but the audit could extend to these workers as well.

Next the auditor will look to control issues to determine if the worker should be classified as an employee – behavioral control, financial control, and relationship of the parties. Agents look at duties, responsibilities and degree of supervision. They will also check to make sure the independent contractor is not offering the same service that your company offers. For example, if your company offers legal services and your hire a web designer to enhance your website, he will likely be considered an independent contractor. But if your contractor is a full time paralegal, that could be a whole different ball game.

Another factor that aids in the determination of job classification is common practice. Stated in the IRS Audit Techniques Guide is the following: “A long-standing, recognized practice of a significant segment of the industry based on the geographical location in which the individual does business” can provide relief under Section 530. It then cites a court case General Investment Corporation v. United States, 823 F.2d 337 (9th Cir. 1987) in which a mining company was allowed to treat miners as independent contractors because that’s how it’s always been done.

This holds for real estate companies that hire commissioned sales people as independent contractors. It’s the standard practice in the industry. However, the receptionist who answers the phone and handles the floor at the real estate office had better be paid as an employee.

Of course if you have a private letter ruling or an IRS determination letter to prove that you have permission to treat your workers as independent contractors, show it to the auditor. That will wrap up the issue right then and there.

When it comes to assessing penalties, you may be absolved if you acted in “good faith.” This generally means that the auditor is convinced that you were convinced that you had been classifying the worker properly and also that you had issued the required 1099s.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.