Collabrus™ Expert Compliance Blog

Smart planners see the future and prepare for it before it arrives.

We have a combination of events converging that will eventually result in increased taxes along with tougher enforcement of existing tax laws and tougher IC compliance.  I’ve reported before The Perfect IC Compliance Storm is coming.  Don’t doubt that it is looming on the horizon.  Often people don’t believe anything is significant outside the 24 hour news cycle, but the really important events take longer to develop.  The Perfect IC Compliance Storm is one of those events.

Just to set the stage, consider the following current events:

In California

• Cash is so short that the state controller says to avoid the state government from grinding halt he will be making payments using IOUs unless a budget is passed by July 1.*
• California’s banks haven’t committed to honoring the IOU’s yet.*
• Governor Schwarzenegger is planning to furlough state employees an additional day, for a total of three per month beginning July 1, if lawmakers do not send him an immediate solution for the entire $24 billion budget deficit.*
• The Sacramento Bee reported June 30, 2009 that state employees are scaling back or canceling summer vacations, cutting back on food, entertainment and just about all big expenditures they make, as a result of the furlough days.
• Statewide all Californians are cutting back on spending which has reduced jobs and decreased revenues from state income tax withholding and sales tax collections far below normal levels.

*The California legislature hasn’t passed a budget on time in remembered history.

Regardless what the governor says, it doesn’t take a Tax Rocket Scientist to know California needs to generate additional revenue because the politicians will not cut the full $24 billion from the budget.  That means finding ways to collect more taxes when taxpayers have indicated they don’t want more taxes.  One easy way to collect more taxes is more aggressive enforcement of current tax laws.

Nationally

1. The Wall Street Journal predicts (June 30, 2009) that Washington’s focus in the area of economic and domestic policy will be shifting. The prediction is based on subdued spending and weak national growth, plus an estimated average federal deficit of $1 trillion annually over the next 10 years. The Journal predicts the president and congress will be forced to shift their priority to:  a) increased taxes, b) reduced spending, and c) increased tax law enforcement
2. May 2009, IRS Commissioner Douglas Shulman told Congress he is placing more importance on greater enforcement as a method of closing the “tax gap.” He stated he will use the increased IRS funding he received this year to hire 4,500 new revenue agents.
3. IRS Deputy Commissioner Linda Stiff noted that these new agents are the “largest hiring initiative” (for the IRS) in recent years.
4. The new IRS accountants, economists, statisticians and revenue agents are part of an ongoing federal effort to close the tax gap by accelerated income tax collections and increased enforcement of existing tax laws, including stronger enforcement of IC compliance.

Prepare for The Perfect IC Compliance Storm now

When you know a storm is approaching it makes sense to insure you are protected.  Waiting until after the storm hits you and then spending money repairing the damage is not good business.

Over the years, I’ve found some employers are unaware of specific conformity laws intended to protect their company, but due to confusion around reporting, these laws caused more harm than help. So I thought I’d take a moment to share an example with you. You can thank me later.

Essentially, there are federal “conformity laws” for multi-state workers that apply to all states.  These laws are designed to protect your company from withholding and paying taxes twice for the same employee under the same wages in two different states.  However, I’ve seen two common situations where employers try to simplify their reporting.  In the first situation, an employer will declare all workers (in and out of state) as having worked in only one state.  Guess which one? The state of their home office or headquarters.  The other situation I’ve seen, again to simplify reporting, is where a company will classify all out of state workers as ICs and in-state workers as employees. 

Doing either of these can cause trouble later on.

When this causes a problem

Usually this situation doesn’t become an issue until the worker, who resides in and performs most of, or substantially all of, his or her work in a different state, becomes unemployed and files a claim.  The Department of Employment in the home state of the worker, where he will typically file his claim, looks into their data base and finds no wages reported for him.  They then discover he had been working for a company headquartered in a different state.

That’s when the audit reciprocal agreement program kicks in

For example, let’s say a company headquartered in California is employing the services of a worker in Nevada.  This worker becomes unemployed and files a claim in Nevada. Nevada’s Department of Employment will contact California’s Employment Development Department and ask the CA EDD to investigate the proper benefit and tax reporting status for this worker.

If the company headquartered in California has been handling the worker as an independent contractor, the reciprocal agreement allows for Nevada to ask California EDD to determine:

• If the worker was properly classified as an IC
• If the worker was misclassified as an IC, in which state he or she should be covered as an employee
• If improperly reported to Nevada (for example) and determine the necessary wage data for Nevada to make tax assessment for back taxes and pay benefits

EDD will use the federal rules to decide which state the worker should be reported. 

If a tax assessment is levied from Nevada (for example) there are also provisions for California to assist in collecting the taxes, penalties and interest if necessary.

For the company’s sake, I wish I could say this is where they stop

However, the EDD doesn’t like to go out and investigate or audit one state, in this case Nevada. When the EDD auditor is out in the field he or she will typically conduct a California tax audit, too.  Double Jeopardy.

ABC NEWS reported on May 27, 2009, that, “Millions of Americans in the past year…have lost their jobs as a result of the financial crisis. While many collect their unemployment and send resumes, a growing number of these displaced workers are striking out on their own…”

These highly skilled, and experienced, professionals want to make an impact where they see opportunity. However, without the funding of their struggling employers, they know that opportunity is lost.  They have decided to strike out on their own and carve their own career; a business for which they are responsible and where they can depend on their own efforts.  Most of these professionals are very good at what they do and know how to be successful.

Advantages of engaging independent consultants or contractors (ICs)

These temporarily displaced veterans of the business and high tech world can be a treasure for your company.  They are fresh new entrepreneurs and offer numerous advantages:

• As ICs, they can provide a cost savings to your business.
• Engaging them does not require a long term commitment.
• They have experience, skills, abilities, knowledge and a fresh point of view you may not currently own in your company.
• ICs are very eager to be a success.
• These professionals are not just sending out a resume and sitting around waiting for the phone to ring.  They have a more aggressive and innovative approach to their profession, which they will bring to your company’s project.

In my opinion these fresh new entrepreneurs add a huge value.

Be sure your new consultants and contractors are ICs beyond a title

Unless you have an up-to-date in-house expert to help you set up the relationship, or a credible third party vender, you may be taking on an element of unexpected risk by engaging an IC.

Many times, these individuals have a great set of technical skills and experience but are unaware of how to properly position themselves and establish the engagement as an independent business person.  From my experience most companies also do not know how to safely engage these new entrepreneurs.  That is why enforcement agencies like California’s EDD and the IRS find such a high level of misclassified workers when they audit a company for IC compliance.

Remember, in tough economic times the government is actually funded at higher levels to increase its compliance enforcement activities.  So while you are cutting back on costs these agencies are investing in finding misclassified workers.  Also, since more people are applying for unemployment benefits (a top audit lead for both state and federal enforcement agencies) the odds of questioning true employment increase.  If someone you recently terminated as an IC applies for unemployment benefits, it is likely an auditor will turn to you, his or her last “employer”. 

This is not a good time to take chances with IC compliance.

Why to partner with a compliance expert to help you engage ICs

Companies like Collabrus or M Squared Inc, have the trained resources to assist you in finding a qualified IC.  They also help you to properly engage them so your risks are minimized.  Doing this correctly may require the classification of a consultant as a W-2 for the duration of the engagement, or as a 1099 by the vendor company, but either way you will be protected.

One last bit of advice

When you use an outside service use the best.  I’ve seen some third party vendors say they are protecting clients but cut corners on the qualification and classification processes to increase their profits and leave the client companies exposed to high risk.

Short answer: If the LLC is organized as a corporation, and is not an attorney, then a 1099 is not required.

LLC’s can be organized in different business structures

“LLC” means “Limited Liability Company.”  A LLC is not necessarily a “Corporation.” A mistake many people make is to assume that anyone with an LLC is incorporated. An LLC may be organized as:

• A sole proprietorship
• A partnership
• A corporation
• A few other less common forms of business entity

You treat the LLC depending on how it is organized

The owner of the LLC makes a selection of the business structure when the LLC is formed and from that decision other consequences follow. For example if the LLC is set up as a sole proprietorship and provides services to your company then you must issue a 1099. Partnerships that provide personal services to your business must also receive a 1099.*

When a LLC does not receive a 1099

If the LLC is organized as a corporation then it is treated as a corporation. You are not required to issue a 1099 for payments made to a bona fide corporation. There is an exception, so keep reading.

Special case for attorneys

However, there is a special provision in the IRS rules for attorneys. If you pay an attorney for services to your business, even if the attorney is incorporated (via LLC or not), you must issue a 1099 to report the payments.*

One last word

I recommend to my clients that when they are engaging a consultant who states he/she has a corporation, they verify the corporation’s current status. Ask for a current copy of the Certificate of Incorporation, showing the corporation is properly registered and all fees are current. It‘s not uncommon for a consultant to initially form a LLC as a corporation, and then as time goes by allow the corporation to become inactive. However, the consultant continues to represent himself as an active corporation. This can create a real problem if you are audited by a government agency.

* In all discussions above I’m assuming you pay over $600 to the LLC during the year, which is the threshold for issuing a 1099.

The American Recovery and Reinvestment Act (ARRA), enacted in February of this year, created or expanded a variety of business tax deductions and credits. Because some of these changes are only available for 2009, you may only have a few months to take action and save on taxes.  Even though I’ve covered this topic before this is a good time to remind you of these one time opportunities.  For example:

COBRA Credit

Employers that provide the 65 percent COBRA premium subsidy provided for under ARRA to eligible former employees may claim credit for this subsidy on their quarterly or annual employment tax returns (Forms 941 or 940). Doing this allows you to reduce the employment tax deposits you make by the amount of the credit, which may improve your cash flow.

The Consolidated Omnibus Budget Reconciliation Act of 1985, commonly referred to as COBRA was amended by ARRA to allow the temporary continuation of COBRA health coverage at group rates for former employees, retirees, spouses, former spouses and dependent children. The new COBRA subsidy provisions also apply to insurers required to offer continuation coverage under state law similar to the federal COBRA.

The former employee pays a premium for COBRA

Eligible individuals will have to pay 35 percent of the premium to their former employers.  To qualify, a worker must have been involuntarily separated between Sept. 1, 2008, and Dec. 31, 2009.

The employer takes a credit

Employers must treat the 35 percent payment by their former employees as full payment, but the employers are entitled to a credit for the other 65 percent of the COBRA cost on their payroll tax return.

For more details

See my April 14^th article on this topic in the NEWSFLASH section of this website. Also, you may go to www.irs.gov, under “Frequently Asked Questions” and get more information the IRS has provided about this temporary credit.

Actually this happens quite often.

I can think of four options.

1. Continue employing the misclassified worker until you are caught up in a misclassification action such as an employment tax audit, workman’s comp claim, or civil lawsuit.
2. Terminate the relationship as soon as possible.
3. Legitimately change the relationship back to an Independent Contractor now.
4. Begin reporting the worker as an employee retroactive to the beginning of the calendar year. That way there is instant protection for you and the consultant, and a W-2 is issued for the entire year.

Let’s look at the options one at a time.

Option 1. Continue employing the misclassified worker until you are caught up in a misclassification action such as an employment tax audit, workman’s comp claim, or civil lawsuit.

There’s really not much to say about this option. It’s the Ostrich Head in the Sand System of Compliance.  You may be following this course right now, but I don’t recommend it.

Option 2. Terminate the relationship as soon as possible.

The statute of limitations are variable depending on the circumstances and the actual action that will hit you; however, the sooner you stop the practice the sooner the statue begins to run out and the sooner you can see the light at the end of the tunnel.

The down side is obvious-you lose a valuable consultant and they may file for a wrongful termination suit against you-sour grapes-what you were trying to avoid…

Option 3.  Legitimately change the relationship back to an IC now.

If you recognized the relationship drifted, then put it back. It’s pretty straight forward.

The downside is this is sometimes easier said than done. Maybe the consultant has become an integral part of your company the way services are now provided and you don’t want to give up the control you have over them.

Option 4.  Begin reporting the worker as an employee retroactive to the beginning of the calendar year, so there is instant protection for you and the consultant, and a W-2 is issued for the entire year.

You probably can tell, I consider this the safest, and best, of the options. As of that moment, assuming no actions have already been taken against your company, your risk begins to decline steeply. In three years or so, your exposure for the tax, or civil suits, completely goes away and you still have your valuable employee.

The downside is the slightly higher cost of employee benefits and employer taxes, over an IC without those costs. Also some consultants will resist this change because they have a sweet deal with the stability of an employee and the tax breaks of an IC. This is one reason the IRS considers misclassified 1099’s a significant contributor to the Federal Tax Gap. It’s what will put you in jeopardy of an audit.

Not taking action because of “push back” by the consultant is analogist to saying, My car is speeding out of control towards a 1000 feet cliff, and in danger of going over, but I don’t want to stop because it may put wear on my brake pads.

Warning: Do something now! Don’t wait! Take positive action to change before you are caught in a misclassification action.

If you’ve been breathing air on this planet for the past six months, you should realize there is The Perfect Storm of Independent Contractor Compliance threatening American businesses. It’s on the horizon and swiftly approaching.

Governments at all levels are looking for more money

Politicians are looking for money because there is not enough in the budget to cover what they are spending. You don’t believe it? Just a day after California voters said “Enough!” by voting down every tax increase scheme proposed by the legislature in the special election (except the one meant to appease taxpayers with no pay raises for lawmakers in the years of a deficient) the California lawmakers are already looking for an “end run” strategy for increasing the money they collect from taxpayers.

For example, California Assembly Speaker Karen Bass said, “We obviously aren’t going to start with (tax increases), but that is possible to be in the mix…”

Republicans are calling for “deep cuts” while Democrats are saying they won’t compromise their values about government programs.

There is one thing both Democrats and Republicans almost always agree on.  The current tax laws can be enforced more aggressively when they need money. It’s one politically safe way to get more money without passing a bill to raise taxes.

As a result governments will soon be taking extraordinary measures to enforce IC compliance laws and collect every possible tax dollar.

At the federal level

In the past year the following bills have been proposed to help close the infamous “Federal Tax Gap” (reported at $345 billion per year):

• Employee Misclassification Prevention Act
• The Taxpayer Responsibility, Accountability and Consistency Act

• The Obama-Durbin Independent Contractor Proper Classification Act (That’s right!  Our current President was the co-author).

At the state level

In California for example, SB 1490, introduced last year, but sidetracked temporarily, would increase enforcement with the promise to bring in more money (For more details go back to my article on SB 1490 in July 2008).

The governor currently has a special “tax commission” looking at ways to “overhaul the California tax system”: I think it almost goes without saying, during a time of financial crisis, if you form a tax commission to discuss changes needed in California’s tax law…

The Perfect Storm of IC Compliance

This is why I call it the Perfect Storm of IC Compliance. The voters won’t let government raise the rate of taxation, so the politicians will find an “end run” to raise more money. IC Compliance is a popular route to increase tax collection.

You should prepare your company now

I’ve been recommending that companies ensure their compliance ship is seaworthy now, before the storm hits. If you’d like to know a lot more about this tax environment, and how to insure you are protected, why not sign up for my free seminar on June 3, 2009, in Mountain View, California.

You can find information on signing up on this website.

If you do, take a look at a few excerpts taken from a single State of California website of the Economic and Employment Enforcement Coalition (EEEC).  There are many more “Press Releases” on this and other government websites, documenting the aggressive actions being taken to fine and penalize businesses for not following labor and employment tax laws, especially in California.

Here are a few recent examples:

May 7, 2009, Los Angeles-State investigators from the Economic and Employment Enforcement Coalition (EEEC) issued citations over $130,000 for multiple labor law violations to a Los Angeles restaurant owner found to be operating illegally for more than ten years. The Los Angeles District Attorney was notified and is now investigating the company for operating without workers’ compensation coverage.

May 5, 2009, San Francisco, CA- Investigators from the California Labor Commissioner’s Office issued over $770,000 in fines to businesses in the car wash industry for numerous labor law violations during a statewide enforcement effort last week.

April 24, 2009, Santa Rosa-A referral made by California’s Division of Occupational Safety and Health-better known as Cal/OSHA, to the Sonoma County District Attorney of a Santa Rosa roofing company for violations of state safety regulations leading to the death of one roofer and the permanent disability of another has resulted in a conviction of two felony counts for violating State worker safety laws.

April 23, 2009, Sacramento- Today Acting Secretary Doug Hoffner released the following statement after the San Joaquin County District Attorney filed Involuntary Manslaughter charges and California Labor Code violations in the May 2008 death of 17-year-old farm worker Maria Isabel Vasquez Jimenez.  The case brought against Merced Farm Labor followed an investigation by the Division of Occupational Safety and Health-better known as Cal/OSHA, which revealed neglectful acts on the part of the employer. Following the referral to the District Attorney, Cal/OSHA collaborated to bring forward information needed for the prosecution.

April 17, 2009, Los Angeles-California Labor Commissioner Angela Bradstreet and Attorney General Edmund G. Brown have prevailed with a judgment totaling $13,640,819 against janitorial companies Excell Cleaning and Building Services Inc., a Delaware Corporation and M.O. Restaurant Cleaning of California Inc., a California Corporation.

March 30, 2009, San Francisco-In a continuing enforcement effort of California’s public works laws, the State Labor Commissioner issued an Order of Debarment against All Floor Commercial and Residential Flooring of Campbell and company owner, Salvador Elias Perera, prohibiting them from bidding on or receiving any public works projects for three years. The prohibition, officially known as a debarment, begins on May 15, 2009.

Dec. 23, 2008, San Diego-California Labor Commissioner Angela Bradstreet yesterday filed a lawsuit with the Superior Court of California, County of San Diego in unpaid wages totaling close $250,000 against Einstein Industries Inc., a San Diego online health care and legal marketing company.

November 12, 2008, San Francisco-State investigators from the California Labor Commissioners’ Office issued 71 citations totaling $267,600 in fines in a two-day statewide enforcement sweep of businesses in the agricultural industry including nurseries, greenhouses, landscapers, farm labor contractors, dairies, growers and other agricultural businesses.

September 16, 2008, San Francisco-California Labor Commissioner Angela Bradstreet has prevailed in a federal lawsuit filed by a personal talent manager who sought to challenge the constitutionality of the California Talent Agency Act (TAA)….Bradstreet said following last week’s ruling.  “If you procure employment for talent in any form you must be licensed as a talent agent or face legal action against you.”

There were more

The point is the State of California has a very aggressive program to penalize businesses that are not properly classifying and paying their workers.  These “raids” usually focus on certain industries then move on to other industries when the enforcement agencies decide there is a greener pasture. You need to get things in order before they graze in your pasture.

I recommend that you be honest-only you will know how you answered these questions.

• Do you classify consultants and temporary workers as IC’s because it saves money?

• Have you ever said to an applicant, something like, “We aren’t hiring employees, but we have an opening for an independent contractor?”

• Is it possible that any of your former IC’s will file for unemployment insurance?

• Is it possible an IC can become injured while working (car accident, carpel tunnel, stress, slip on the floor in the break room)?

• Have you ever “terminated” an IC, without completing the contract, for poor performance?

• Are you deciding who is an IC and who you put on the payroll based on budget considerations?

• Do you have “independent contractors” or “consultants” who have been providing services, or working on a series of projects job-after-job, year-after-year, but are not on the payroll?

• Do your IC’s report to a manager in your company on a day-to-day basis?

• Do any of your IC’s supervise your employees?

• Do your IC’s work exclusively for you and not for any other clients (such as your competitors)?

• Do your IC’s routinely attend regular employee meetings?

• Do you expect your IC’s to work full time on your project, with no time for any other business associations?

• Have you issued a Form 1099 and a Form W 2 to the same individual in the same tax year?

• Do you provide expense reimbursement for your IC’s?

• Do you provide a work location, supplies, or equipment for your IC’s?

• Do your IC’s work in your business, side-by-side with regular employees, doing similar duties, under similar circumstances?

• Are you just presuming you are safe with the classification of your independent contractors because it’s always been done that way and you haven’t gotten in trouble yet?

• Do you call them independent because it’s company policy to make all temporary workers Independent Contractors?

• Do you believe you can adequately protect your company against misclassification without engaging an expert?

If you answered yes to ANY of these questions your company is probably at a high risk level of being involved in a misclassification conflict.  These include government enforcement agencies, civil lawsuits, or both.

In my experience most companies do not have a reliable system in place to insure they are properly classifying and handling their contingent workers and IC’s. When they are challenged, they find out the hard way they were not prepared or properly protected.  By then, it is too late.

Preparation starts now before the challenge.

Call now and get the help and protection your company needs.

A professional website (AccountingWEB.com) is warning CPAs to prepare their small business clients for an increased IRS audit effort. Accountingweb.com provides accounting news, information, tips, tools, resources and insight to assist CPAs and other tax professionals to better serve their clients.

What is a “small business” from the government’s point of view?

Based on my experience working in government we classified a small business as having less than 100 employees. In some cases, 250 employees is the dividing line.

What was the warning?

A recent article on their website warns: “Past due payroll taxes can cause you to lose your business and in some cases, your freedom. The IRS is focusing increased tax compliance efforts on small businesses so it is important to know the common payroll tax audit triggers and learn how to avoid severe IRS penalties, huge tax debt and federal criminal investigation.”

What are payroll tax audit triggers?

I cover the “top triggers” of an payroll tax audit in my Breakfast Briefings, which are free seminars covering a host of topics about independent contractors, tax audits, and how to protect your company. It could be the best spent two hours you’ve spent in a long time. If you are interested in attending one, you can find more information on this website. Hopefully I’ll see you there.

The article goes on to advise CPAs that:

• “…the IRS tends to focus their enforcement efforts on small businesses, especially during economic downturns.”
  

• You can lose your business due to extremely aggressive IRS collection tactics for past due payroll taxes.”
  

• “…There are three major penalties you can be hit with (failure to file, failure to deposit, and the failure to pay), which can add up to about 33% plus interest…”
  

• “…The IRS can come after business owners individually for payroll taxes owed. The IRS can access what is called the Trust Fund Recovery Penalty (TFRP) against owners and shareholders. The IRS is the only creditor on the planet that can “pierce” the corporate veil and go after individuals…”

There is more…

Actually, the author of this article neglected to note that under Section 1735 of the California Unemployment Insurance Code California’s EDD can also pierce the corporate veil and collect from the responsible corporate officers directly and personally, for payroll tax liabilities, including penalties and interest. The EDD is much more aggressive in this area, and after hitting you with a large state tax assessment, will typically share the information with the IRS-a double threat.

If you are a professional take responsibility for your company’s welfare now!

The points made in this website article are well taken and as professionals (CPA’s, HR Directors, Procurement Managers, or others involved in engaging IC’s) you must look out for the well being of your company. You need to be sure your company is prepared before the government knocks on your door, or before you are slapped with a class action suit for misclassifying your contingent workforce.

The IRS and state agencies will be increasing their efforts to identify misclassified workers.

Why? Because it generates revenue for the government. Finding misclassified workers results in large tax assessments going back for several years with penalties and compounded interest added.

Take action now!

The perfect IC Compliance Storm is on the horizon. I recommend you prepare now by insuring you can withstand an audit or civil challenge of your independent, contingent workers. That means engage a professional who is an expert in IC compliance.