IRS Gets Class Conscious: Switching to Independent Contractors Draws Scrutiny

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Photo of Annette Idalski by Alex Martinez

Shifting from full-time employees to independent contractors is a recessionary cost-cutting measure some businesses implemented. But for those who have misclassified their workforce, the glare of the IRS spotlight may soon be upon them. Over the next three years, the Internal Revenue Service is auditing 6,000 randomly selected businesses to determine whether they have workers who’ve been classified as contractors when they should be treated as employees. When appropriately done, classifying a worker as a contractor allows a business to escape unemployment, Social Security and Medicare taxes and overtime pay. Additional taxes, penalties and interest result from worker misclassification.

“The Department of Labor is also cracking down,” says Annette Idalski, chair of the labor and employment litigation group at Chamberlain, Hrdlicka, White, Williams & Martin in Atlanta. “We’ve seen a 50 percent increase in our DOL activity. Several employers have been hit with DOL audits … and are facing devastating damages calculations on back pay alone.

“Oftentimes, these findings are incorrect and employers should be prepared to set the record straight.”

A tip-off to the feds comes when a worker files for unemployment benefits identifying a business as a W-2 former employer. “The IRS’ standard information request is directed at companies who have provided a worker with both a Form 1099 and Form W-2,” says Tom Cryan Jr., a member at Miller & Chevalier in Washington, D.C., who has defended companies in IRS audits. “Businesses should have only issued Form 1099s, not W-2s, to contractors.”

More tormenting for unsuspecting business owners is that a voluntary correction may actually be waving a red flag attracting an investigation.

“Right or wrong, worker misclassification is viewed by the IRS as a loss of revenue,” Cryan says. “Correcting a mistake may signal an ongoing misclassification. It’s easy for the IRS to discover changes in worker classification through the audit process.”

The workforce should be structured with the Labor and IRS worker classification audits in mind. “It ought to be raising an eyebrow if the individual reports to your office every day and performs functions for your business, yet no one else. That’s the situation that the IRS is looking for with these audits,” Cryan says.

Idalski agrees: “Companies should be wary of laying off workers only to hire them back as independent contractors. The Department of Labor applies a similar test to that of the IRS in determining whether the rehired worker is really just doing the same thing but with a different status.

“We recommend businesses conduct a comprehensive audit of the written independent contractor agreements in place,” Idalski says. “Provisions covering the day-to-day operations, who does what, who’s in charge, equipment, policies and procedures should be included.”


Common situations where an unintended misclassification occurs involve “semi-retiring workers who, because they are scaling back in hours worked, may be shifted from full-time employee to contractor status while they are performing the same functions. Or sometimes a worker requests that the worker’s business be hired instead of adding the worker to the payroll,” Cryan explains.

The 20-factor IRS test offers guidance when classifying workers. The degree of importance afforded any one factor depends on the context in which services are performed. If worker misclassification occurs, section 530 of the Revenue Act of 1978 provides “safe harbor” treatment when the business shows:

1) There was a reasonable basis for treating a worker as an independent contractor.

2) It has treated substantially similar positions consistently.

3) All required federal tax returns were filed consistently with its treatment of the workers.

Because of the 20-factor test, both Labor and IRS audits are factually intensive, time-consuming processes. Though no quick fix exists for a business experiencing these audits, minimizing the tax hit may be possible.

“The IRS Classification Settlement Program can be a cost-efficient resolution for audited businesses that have improperly classified workers,” Cryan says. “Generally, 10 cents on the dollar is a CSP settlement on additional amounts due. For a company to participate in the CSP, it has to agree to be bound by the correct classification for future tax years.”

Susan A. Berson is a partner with the Banking & Tax Law Group of Leawood, Kan. An author of several finance books for lawyers, she may be reached at .(JavaScript must be enabled to view this email address).

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