Auditors Crack Down on ‘Independent Contractors’

Posted on April 6, 2010. Filed under: Tax Tips | Tags: , , , |

( — If your business uses independent contractors, get ready for new scrutiny. Hoping to boost tax revenue, the IRS and many state governments are cracking down on how companies classify their workers.

When employers report wages for independent contractors on IRS form 1099, rather than a W-2, they aren’t required to pay unemployment insurance, worker’s compensation insurance or payroll taxes for them. But the rules governing which workers are genuinely “independent” are strict — and often flouted.

The Internal Revenue Service (IRS) launched a program last month that will randomly examine 6,000 companies over the next three years for employee misclassifications. The federal government estimates it will raise $7 billion over the next 10 through tighter enforcement.

The IRS audit program is just the beginning of what will be “a new era of compliance,” says Gene Zaino, president and CEO of MBO Partners, a services firm that specializes in the independent contractor market. “Most states are now sharing data with the IRS, and many have set up task forces specifically [to address] misclassification. It used to be that if a business ran into trouble with a state labor department or with the IRS, the issue was isolated. Now, any kind of audit or compliance finding can set off a domino effect where the other agencies will get in on the action. ”

Getting audited can be scary even for businesses that keep everything by-the-book. Chris Daly, co-owner of Kinespirit fitness studios in New York City, got an audit notice in January from the New York State Department of Taxation’s Unemployment Insurance Division, which wanted to probe Kinespirit’s use of contractors. Like more than 30 states, New York has run out of money in its unemployment compensation fund and is borrowing from the federal government to keep paying claims.

“We knew we were doing it right but that doesn’t mean we weren’t concerned,” Daly says. “We understand the situation states are in; unemployment insurance is a needed tool, and we understand the need to fund that tool. And there are companies out there that don’t want to fund their share.”

Kinespirit classifies its managerial and administrative staff as employees and its fitness trainers and instructors as contractors. The audit process was exhaustive, but the company emerged clean.

Following the rules: So what’s the correct definition of an independent contractor? It depends on who you ask.

Some business advisors say a true independent contractor is employed by a separate corporation or legal entity, either one they own or a third-party firm. That rules out freelancers who don’t formally set up a business structure to house their 1099 income.

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