By: Pam Wright, CPA
Manager, Assurance Services
With the increased need for revenue and the budget deadline approaching, the IRS is yet again taking action to build its coffers.
An area of focus lies on the proper classification of independent contractors vs. employees in the workplace. The IRS has approximately 6,000 random business audits coming up to address this issue. Organizations generally will use an independent contractor due to lack of resources internally and also for cost-cutting benefits. The issue at hand is the understanding the proper classification between an independent contractor and an employee. Basically, the federal government is looking to collect unpaid payroll taxes.
Why are some nonprofit organizations treating workers as independent contractors?
It’s not just the IRS that is facing hard times. Nonprofit organizations all over the country are looking for ways to cut costs, including using, or at least classifying someone to be, an independent contractor.
Nonprofit organizations incur various costs associated with employees, such as social security, Medicare, workers compensation, health insurance, and retirement benefits, just to name a few. Merely taking into account the employer’s share of social security and Medicare would save an organization 7.65% of payroll costs.
With the current economic environment and many individuals seeking employment (regardless of whether or not the organization is going to pay benefits), it makes sense for organizations to take this route. The issue here is whether organizations understand the difference between independent contractors and employees.
So what exactly is the IRS looking at?
In order to determine if a worker is an employee vs. an independent contractor, the IRS is going to focus their examinations on the control of the individual providing the service. Specifically, they will be looking into the behavioral control, financial control, and relationship between the payer and service provider.
Behavioral control is whether or not the organization is providing training, giving detailed instructions as to the steps for completing the project and the specific evaluation process of the organization.
When evaluating financial control, the IRS will focus on items such as whether or not the service provider has the opportunity to make a profit or incur a loss, whether or not the organization has a significant investment in the project (i.e. are the organization’ equipment and facilities being used or is the service provider using their own) and is the organization reimbursing for expenses in the manner they would for a typical employee. In addition, method of payment such as paying per hour, salary, commission or a flat fee per job plays a large factor.
The IRS will also be looking at the type of relationship, for example if term is more permanent versus short term, i.e. does the service provider work for a number of organizations. If the organization happens to be paying any type of benefits to the service provider, this also will trigger the possibility of an employee relationship.
What if the IRS determines that someone I treated as an independent contractor is an employee?
Depending on the nature and extent of the specific issue, the penalties can be substantial.
If it was an unintentional act and the organization did file a 1099 for the services (which is required in most cases for independent contractors receiving more than $600 a year), the employer will owe tax equal to 1.5% of the payments to the employee, 20% of the employee’s FICA liability, and all of the employer’s FICA liability.
However, if a 1099 was not filed, payment to the IRS doubles. The employer will owe tax equal to 3% of the amount paid to the employee, 40% of the employee’s FICA liability, and all of the employer’s FICA liability.
On the other hand, if the IRS determines that this was an intentional misclassification, the employer may be liable for 100% of the employee’s FICA liability, the employee’s federal income tax withholding as calculated by the IRS and the employer’s share of the FICA liability. And, let’s not forget to add on the typical fines and penalties which the IRS imposes for failure to file the payroll tax returns.
Determining your classifications – “How do I know if I’m choosing the right category?”
When it boils down to it, are you supervising the process along the way, do you share some of the project responsibility and are you assisting the service provider – or are you simply receiving an end product? When evaluating those providing services to your organization, the following are a few questions you may want to ask.
Attributes of an independent contractor:
- Can the worker make a profit or suffer a loss as a result of the work, aside from the money earned from the project?
- Does the worker have an investment in the equipment and facilities used to do the work?
- Does the person work for more than one organization at a time?
- Does the worker offer services to the general public?
Attributes of an employee:
- Do you have the right to give the worker instructions about when, where, and how to work?
- Do you train the worker to do the job in a particular way?
- Do you hire, supervise, and pay the worker’s assistants?
- Do you set the worker’s hours?
- Must the individual work on your premises, or do you control the route or location where the work must be performed?
- Do you provide the worker with equipment, tools, or materials?
Contact your BCG&Co. advisor if you have questions about whether your arrangement with independent contractors will withstand the scrutiny of the IRS.
By: Elizabeth Reidy, Assurance Services
