1. Increased responsibility for non-core tax administration duties,
2. Increasing demand for taxpayer service,
3. Declining resources to meet demands

In her explanation she stated:

• The IRS has set a target for FY 2010 of answering only 71 percent of calls from taxpayers seeking to speak with a customer service representative about account questions, down from 83 percent in FY 2007.
• The IRS examination and collection practices have been developed piecemeal…
• The IRS does little to encourage voluntary compliance. That often business taxpayers who have been subject to a desk audit, or examination, show a decline in voluntary compliance in subsequent years.
• The IRS collection practices often harm taxpayers without producing revenue. One reason cited in the report is the IRS’ tendency to take enforcement actions without regards to effectiveness or their effects on the ability of the taxpayer to survive.

The bottom line? There isn’t enough money for the IRS to do all of these things correctly.

Reading through the report the reoccurring (and often implied) theme is to give more money to the IRS and then the immense agency will be able to do a better job.

This is not a new theme! The IRS has been under increased pressure to become more efficient in collecting taxes, including federal employment taxes, for many years. In fact, last year the General Accounting Office issued a report to congress finding that the IRS is not achieving compliance in the collection of federal employment taxes. (Keep in mind the IRS estimates 15% to 25% of the well publicized Federal “Tax Gap” is related to 1099 misclassification and underreporting issues).

Don’t cry for the IRS. It gets usually gets more money during tough economic times…

The American Recovery and Reinvestment Act of 2009 increased IRS funding to hire 4,500 new revenue agents for the purpose of closing the tax gap.

How are these new agents being used? Well in part to go after misclassified 1099 workers. In May 2009, IRS Commissioner Douglas Shulman told Congress he is placing more importance on greater enforcement of worker misclassification as a method of closing the “tax gap.” He announced the IRS will conduct 6000 employment tax audits in 2010 as a pilot to determine the extent of non-compliance.

Now the latest Taxpayer Advocate report to Congress is saying the IRS needs more money to improve taxpayer service, measure IRS effectiveness and improve voluntary compliance. When they get the money you can be sure they will reach out and touch more businesses.

Have you prepared for the knock on the door?

The reason the number is so high is because tax agencies rarely select a company for an employment tax audit unless they suspect there are misclassification errors. This means the auditor shows up the first day with the pre-conceived idea that your business has done something wrong. Of course, no government agency will officially tell you this, but it’s the way tax auditors think.

Auditors believe most, if not all, companies misclassify their workers. Why?

Just out of the gate: The IRS estimates 48% of all 1099’s represent misclassified workers. That’s just 1099’s! This statement shows that auditors, and their bureaucrat bosses, believe most companies are misclassifying workers. Where did this belief come from?

All tax agencies follow a detailed filtering process to identify and select companies for audit that appear to have misclassification issues. This process includes such factors as:

• Correlating reporting practices,
• Internet searches,
• Government data bases,
• Complaints from former employees,
• Complaints from competitors,
• Type of industry,
• News articles and various other sources. 

It’s a miracle the government only finds + 70% misclassified, because by the time an audit case is assigned to an auditor for investigation, there’s almost a 100% probability the company is “out of compliance.” This is why an auditor who has been on the job for several years forms the attitude that most cases will result in finding misclassified workers.

It becomes the auditor’s reality-the expectation…

These beliefs, experiences and resulting expectations become a self-fulfilling prophecy.

Auditors will keep looking until they find misclassification errors. Their supervisors, who also share this reality, will begin to suspect the auditor isn’t properly doing his/her job if they don’t maintain that +70% misclassification statistic. This combination of case pre-selection and auditor-attitude almost guarantees finding misclassifications.

Actually, the list above is not complete.

If you want to know the complete list of factors, events and actions that will get your company selected for both a state and/or federal employment tax audit, you should attend one of my seminars.

For details on the next seminar, March 17^th in San Francisco, click here.

(If you want to attend a seminar, I recommend you register early. They fill up quickly, and we purposely keep them small so I can spend time talking to each of you privately-but only if you wish).

Possibly a primary reason such a high rate of misclassified workers are found during an audit is the Burden of Proof is on the business.

That’s right. A major reason companies end up with misclassification findings is they can not prove they did it right. The government puts the responsibility to prove the consultant was properly classified on the business, not the IC and not on the government. It is assumed you are wrong and you must prove you are right. Most companies are not prepared and are taken completely by surprise at the level of detail required.

The deck is marked and the other guy gets to deal. Your odds are not good unless you hire a professional to help you play.

To properly protect yourself, you can’t make the contingent worker and IC engagement process a side job. The government auditors are specialists. They typically spend their entire career doing one thing-employment tax audits and ferreting out misclassified workers. To ensure you are protected you should employ an industry expert, like Collabrus, who also specializes in this area and works full-time protecting employers.

The Taxpayer Advocate’s report released to Congress, dated December 31, 2009, lists the type of information that is shared between the IRS and local state enforcement agencies.

The IRS receives:

• The state income information
• Sales information (e.g., from local sales tax returns),
• Personal income tax withholding information from state agencies.
• State and local tax audit reports.

In addition, to uncover misclassified workers, the IRS exchanges employment tax audit reports, audit plans, participates in side-by-side examinations with state and local government agencies, and collaborates on outreach and educational opportunities as part of its Questionable Employment Tax Practices (QETP) Program.

In California, for example, the Employment Development Department (EDD) and the IRS work closely together on all of these areas of compliance and education.

However, does all this cooperation and information sharing make a difference?

The report stated the IRS acknowledges that traditional metrics are not good measures for these programs because they do not capture the impact of the program on future compliance. The IRS wants to develop practical measures so it can tell if the program is “encouraging future compliance” after an audit or examination for misclassified workers.

(In my experience “measuring” and “encouraging” future compliance really means the IRS wants to closely monitor audited businesses in subsequent years and quickly punish any that have not complied with the IRS audit findings).

The IRS wants more money from Congress to fix their problems.

(If you recall, the American Recovery and Reinvestment Act of 2009 just increased IRS funding to hire 4,500 new revenue agents for the purpose of closing the tax gap).

Reading through the report, the reoccurring theme is to ask Congress for more money so the immense agency will be able to do a better job at using the information it currently receives from the states. Some of the money will be used to monitor audited businesses to insure they continue to comply in the future. 

For justification, the report cited that voluntary compliance in the future is sometimes diminished after the IRS conducts an examination.

The report cited examples of taxpayer businesses actually becoming less compliant after they had been audited or examined by the IRS. The Taxpayer Advocate speculates one reason may be the taxpayer realizes after such an experience the IRS does not identify all misclassifications, or other errors.

The report is telling Congress that more money will bring more compliance (and more tax revenues), because the IRS will have more resources to find errors and to follow up on these delinquent taxpayers.

Have you prepared for the knock on the door?

I’ve been reporting for the past couple years that the federal government, and most states, are cracking down harder on worker misclassifications. I’ve told you it is a politically correct way to increase revenue for any government agency that needs money now (which is pretty much all of them!). Doing so is easier than passing a new law to raise taxes. The government can take the position it is only enforcing the existing laws and ensuring everyone is paying their “fair share.” Politicians call it “leveling the playing field” and “protecting the individual workers rights.” They talk about protecting the worker who just wants to earn a living for his family. There have been dozens of bills submitted at the state and federal levels to both make it more difficult and to charge heavier penalties for businesses that misclassify workers. Even President Obama, when he was a US Senator, co-sponsored such a bill. Recently, he publically stated he’d like to see that bill reintroduced and passed into law. Over the past year I’ve referred to this developing trend of tougher misclassification enforcement as the approaching “Perfect Independent Contractor Compliance Storm.”

Now that the “Perfect Compliance Storm” has arrived the New York Times reports on it.

An article published February 17, 2010 in the New York Times, reports that “Federal and state officials, many facing record budget deficits, are starting to aggressively pursue companies that try to pass off regular employees as independent contractors.” The article continues that, “President Obama’s 2010 budget assumes that the federal crackdown will yield at least $7 billion over 10 years.”

Misclassification:  Is it about cheating or is it an honest mistake?

The Times article states, “Many workplace experts say a growing number of companies have maneuvered to cut costs by wrongly classifying regular employees as independent contractors, though they often are given desks, phone lines and assignments just like regular employees…”

The article continues, “Companies that pass off employees as independent contractors avoid paying Social Security, Medicare and unemployment insurance taxes…”

It’s also about income taxes. 

The article cites, “…several studies have indicated that, on average, misclassified independent workers do not report 30 percent of their income.”

If you would like to read the full article go to: 

http://www.nytimes.com/2010/02/18/business/18workers.html

Don’t wait-protect yourself now.

Remember it is too late to avoid the fines and penalties after the state or federal auditors are knocking on your door. Take proactive steps by consulting with an expert, like Collabrus, to learn how to mitigate your risks and protect yourself from a government agency employee classification audit.

Washington DC-The IRS recently issued its 2010 list of “Frivolous Tax Arguments” that it doesn’t want to hear from any of us. One of the highlighted arguments on the list is a Form 1099-OID being used as a debt payment option as a financial instrument drawing funds against the U.S. Treasury…

I normally don’t write about subjects like frivolous tax arguments, and their consequences, but this one was so unusual I thought, why not?

Some background

The purpose of Form 1099-OID (Original Issue Discount) is not for independent contractors. It is to report the original issue discount of holders of OID obligations, like certificates of deposit, time deposits, bonds, debentures, bonus saving plans, and Treasury inflation-indexed securities, that have a term of more than one year. OID is the excess of the stated redemption of the deposit, bond, or other financial obligation at maturity over its issue price.

OID is taxable as interest and must be included in the holder’s gross income.

Apparently someone has attempted to use the Form 1099-OID as a financial instrument to pay off tax, or other, debts…

The IRS warns that, “…Form 1099-OID is in no way a financial instrument (IC or not). It is not a legitimate method of payment of any public or private debt, and it is not a means to withdraw or redeem money from the Treasury(!)…”

The IRS reports that proponents of this theory argue they have sold or transferred their debt to the person to whom they issued the Form 1099-OID in a transaction (How can you sell a debt?).  The issuer of the Form 1099-OID then treats the face amount of the Form 1099-OID as “other income” on the individual’s return. The “other income” amount, however, is not included in the taxable income line.

IRS states, “Persons asserting this theory often significantly overstate withholding and claim an excessive refund in an amount close or identical to the inflated withholding.”

There are huge penalties, including possible jail time for frivolous tax arguments of any type.

Fines range from $5000 per incident (under The Tax Relief Health Care Act of 2006, which amended section 6702, IRC); to seventy-five percent of the underpayment (if civil fraud penalty under section 6663 IRC is applied) leading to many hundreds-of-thousands of dollars in fines.

If the IRS decides someone was attempting to evade or defeat tax under section 7201, a felony, they may assess a penalty or fine of up to $250,000 and imprisonment for up to 5 years for each violation.

Noteworthy is these penalties, fines and jail times apply to all frivolous tax arguments, not just this one.

Whether you’re dealing with investments or independent contractors it really doesn’t pay to be creative in this way. The IRS is not prone to rewarding creativity when it comes to tax payments and reporting.

Just utilize a true expert and be safe.

Clients often ask us for the magic pill, the quick and simple way to know if a consultant is properly classified as an Independent Contractor (IC) or not. The truth is there is no simple test. Common law is a complex area and it takes an expert to make the right decision, or to help you set up an IC relationship properly so that down the road some government auditor, or court, won’t reverse your decision and make you pay significant penalties and fines.

There are, however, some universal Red Flags that shout out “Employee Misclassification.” The questions below will give you some insight about these Red Flags and if your company is at risk or not. Be brutally honest in answering the questions, because an objective third party will. Answer the questions for any consultant you have classified as an IC. Print out this list, take a pen/pencil, and jot down your answers.

Answer ‘Yes’ or ‘No’ to the following:

1. Have you renewed the consultant’s contract several times, with minor changes in the deliverables, which has had the practical effect of extending the initial engagement for an indefinite time period?
2. Do you provide the consultant with a work station at your facility?
3. Do you provide the equipment needed to do the job (a computer, software, office supplies, or other tools)?
4. Do you pay the consultant’s work expenses?
5. Do you pay the consultant by the hour?
6. Do you pay the consultant even if a job needs reworking?
7. Do the day-to-day duties vary for the consultant depending on the needs of the company?
8. Does a manager in your company oversee the consultant’s work and have the ability to insist on reworking or changing the method of doing the job?
9. Has the consultant become exclusively dependent on the work you provide for his/her livelihood because he has either dropped his other clients, or never had other clients?
10. Is the consultant expected to attend regular meetings with your employees?
11. Was the consultant once your employee and now does substantially the same job, under similar working conditions, as an IC?
12. Can you decide what hours the consultant will work?

Scoring

If you answered ‘Yes’ to four or more of these questions for a consultant you classify as an IC, there is a possibility the consultant is misclassified. 

If you answered ‘Yes’ to six or more questions the consultant is almost certainly misclassified.

However, to be completely sure you need to do a more thorough evaluation, because this list is by no means complete and the weighting of each factor will vary depending on a number other circumstances.

One last thought

If you do not know the answers to these questions then your company is at risk. You need to gain control now before it is too late. It’s one of the services Collabrus provides.

I’ve seen the “Status Drift” phenomenon pop up again and again over the years: The three month project that became another three month project that became a six month project that became a semi-permanent engagement ultimately turns into a misclassified employee.

A couple of factors affect a long term relationship to create Status Drift. One of them is financial dependence.

When the IC stops serving other clients and knows he/she can depend on one client to stay busy and keep the money coming in, the contractor becomes financially dependent on a single client. A contractor who is financially dependent on a single client has taken a huge step to becoming a misclassified worker. 

Another factor is incrementally increasing direction and control.

Companies rarely appreciate how perpetuating a temporary relationship, regardless how it’s contractually created, can affect a relationship. A natural, and unavoidable, progression of human nature is that over time control is tightened in subtle increments. The parties grow closer and closer, resembling more and more a employer-employee relationship. Soon the client thinks nothing of dictating the details of how the day-to-day work is performed, or even what work will be done on any given day.

Welcome to Direction and Control…

Everything may go well until an objective third-party observer examines the relationship. 

This can happen when:

• A state or federal tax auditor knocks on your door,
• There is an injury on the job,
• These workers look around and decide they are doing employee work without the benefits and file a co-employment suit

Suddenly you are faced with an unplanned, retroactive cost; a dangerous event in today’s highly competitive marketplace.

Why? Because the examiners only see what the relationship looks like today. They don’t consider how it incrementally changed.

To protect themselves many companies institute some version of an arbitrary 12 month rule. Once someone has worked for the company as either a temporary employee or as an IC for 12 months they are terminated. The company believes this strategy will enable them to avoid several issues from misclassification to civil suites for fringe benefits. This is a simplistic, unnecessary and often ineffective approach. You can lose valuable worker assets with this policy and still not be protected.

It is just as possible to have a misclassified employee who has been on the job for one day!

What’s the correct solution?

The answer is to insure you have properly classified and engaged your independent contractors and are properly handling your temporary employees. If you utilize temporary employees consider the use of a third party vender like Collabrus who will provide a full range of benefits and HR support in their role as the employer of record. Collabrus also helps you to properly classify your contractors and monitor your IC’s to insure your company doesn’t become a victim of Status Drift.

“He’s a ‘1099′ and has always worked as one,” the hiring manager pleaded…  

“He won’t take the job unless we bring him on as an IC.”

Fast forward two years later. The project well has dried up. The hiring manager has to let the IC go.

The Former IC Goes Down to the Local Unemployment Office…

Your former IC needs money. Either knowingly or mistakenly, he files for unemployment benefits.

He’s been working exclusively for you for the past two years and has lost his industry contacts. It’ll take him time, even in a good economy, to connect with another company. It doesn’t take long for your former IC to learn only ex-employees (not ex-independent contractors) are entitled to unemployment benefits.

Consultants have been known to change their recollection of the relationship when they need the money

In his interview with the UI office he mumbles, “It was the only job available…I’m not sure legally what I was…” or something to that effect. The sequence typically goes like this:

1. The sympathetic caseworker, who is bent on paying benefits, sends the file to the local state employment tax audit office to determine the consultant’s correct status.
2. In the meantime, the ex-IC is often paid his benefits on the assumption he was, in fact, misclassified.
3. The auditor receives the assignment to determine if the individual is entitled to UI benefits, which can only happen if the “UI Claimant” was misclassified.

How do you think this will end? And remember this is the tax audit office. They are paid to do tax audits! The system is stacked against you.

When the project was created you didn’t plan on this development.

Remember, this is the same consultant who insisted, even threatened you, to treat him as an IC for the project. So you may not have felt compelled to properly qualify the consultant or the project for IC status and you probably also didn’t maintain the documentation needed to prove you did it right. Now things have changed.

You protest the ruling-your day in court.

Many things have changed over the past two years, including the fact that the original hiring manager is no longer with your company.

When you go to the hearing the consultant will be sitting on the opposite side of the table testifying for the government. He’ll show check stubs, with no deductions, and say he worked fulltime for you. It is his word against yours.

You offer up the IC contract as your proof. The judge takes the contract as evidence then casually sets it aside. Everyone knows little if any weight will be given to its carefully crafted wording, because he has the direct testimony of you and the consultant available to him to illuminate what actually occurred. Direct testimony will outweigh what the contract predicted would occur.

Not to mention the uncomfortable fact that contract law does not supersede employment law.

The burden of proof.

All the IC and the government does is make a few perfunctory statements and then everyone turns to you and the judge says, something like, “So what’s your version?” Credibility being equal, 99 out of 100 times the judge will go with the consultant’s version and rule that they were misclassified.

Ouch! Your company has become the victim of the most common trap in the worker classification world because you didn’t properly protect yourself when the project was established.

What’s happening?

Due by January 31, 2010

• Forms W-2: You must furnish each employee a completed Form W-2, Wage and Tax Statement. You typically have until March 1, 2010 to send the federal government its copies of the W-2, unless you file them electronically then you have until the end of March.
• Form 1099: You must furnish your independent contractors and consultants a Form 1099.
• Form 941: File Form 941, Employer’s QUARTERLY Federal Tax Return, for the fourth quarter of the 2009 and deposit any owed income tax withheld, social security, and Medicare taxes.
• Form 944: File Form 944, Employer’s ANNUAL Federal Tax Return, for the previous calendar year instead of Form 941 if the IRS has notified you in writing to do so.
• Form 940: File Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. However, if you deposited all of the FUTA tax when due, you have 10 additional calendar days to file.
• Form 945: File Form 945, Annual Return of Withheld Federal Income Tax, to report any nonpayroll income tax withheld in 2008.

Due by February 16, 2010

Exempt Forms W-4 have expired: Any Form W-4 previously given to you claiming exemption from all withholding has expired. If you have not received a new form, that renews the exemption; by yesterday you are required to begin withholding today.

Due by February 28, 2010

Paper Forms 1099 and 1096: Send Copy A of all paper Forms 1099 with Form 1096, Annual Summary and Transmittal of U.S. Information Returns, to the IRS. If you will be filing electronically you have until March 31.

Paper Forms W-2 and W-3: Send Copy A of all paper Forms W-2 with Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration (SSA). If you file electronically you have until March 31.

Paper Form 8027: Send paper Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, to the IRS. If you file electronically you have until March 31.

Due by March 31, 2010

Electronic Forms 1099, 8027, and W-2: All the above forms you waited to send until March 31, 2010, are due now. 

Due by April 30, July 31, October 31, and January 31:

FUTA taxes: Deposit federal unemployment (FUTA) tax due, each quarter, if it is more than $500.

Form 941: Each quarter file Form 941 and deposit any un-deposited income tax withheld, social security, and Medicare taxes due. You may pay these taxes with Form 941 if your total tax liability for the quarter is less than $2,500.

There’s more…

I did not include any state requirements and I probably left out a couple hundred, less common federal forms, but I think you can see why government tax administrators get cheered up this time of year.

In addition to the collection of tax revenue, the government employees get access to a rich stream of fresh data to analyze. This is another input which they will use as they select fresh audit targets as they continue their crusade to close the “tax gap.” Be forewarned: they are increasingly focusing attention on independent contractor (1099) compliance, one of the identified “heavy contributors” to the tax shortfall.

Forming a corporation is not a misclassification “magic pill.”

Forming a corporation does not automatically qualify the work for independent contractor status. If it were really that simple, everyone could create a corporate entity and be paid as an IC. The common law factors, the IRS’ 20 Questions, the Three Elements of Law, etc. would be disregarded and the whole employee versus independent contractor issue would go away overnight.

Obviously, that’s not reality.

The type of entity the contractor has formed is only one element to consider.

The fact a worker is incorporated is just one factor in determining a worker’s status. Incorporating (as an S Corp, C Corp or LLC) only indicates the individual intended to create his/her own business.

It is possible to form a corporation and still work as an employee for another company.

It is not unusual for an individual to “step outside” his own corporation and work as a common law employee for someone else. Why? Because you must review all the common law factors to see the total picture of the working relationship. One way to look at this is to ask, “Did we engage an independent business (corporation), or did we hire an individual to perform the work?

It is important that you contract for the corporation to perform the work, not for an individual who happens to have a corporation.

This is a very important distinction.

If you are employing a corporation to do the work, you are contracting for certain specifications or outcomes, completed within a time frame and for an agreed price. You look to the corporation to perform, not an individual who is being paid through the corporation. Therefore, it most likely won’t matter:

• Who actually performs the work,
• What hours the work is performed,
• How many hours it takes to complete the project,
• If the corporation is also providing similar services for your competitors at the same time. 

In contrast, when you engage an individual you may expect him to:

• Personally perform the work,
• Not employ a subordinate,
• Be paid for the time worked as opposed for a completed job.
• Reimburse him for expenses,
• Follow your daily schedule for hours,
• Change activities to meet daily needs,
• Not work for your competitors,

WARNING: If the contractor tells you he/she is an independent contractor of his/her own corporation, where he she is an officer, this is a Red Flag. Corporate officers are specifically included within the definition of employee at both state and federal levels.  An individual, who is incorporated, and who isn’t reporting his/her wages properly is not in compliance and may put your company at risk.

As you can see independent contractor compliance becomes more complex when you’re evaluating a business vendor situation. It pays to have an expert on your side!