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THE DANGERS OF INDEPENDENT CONTRACTOR TREATMENT
Why employers want to treat employees as independent contractors:-
Avoidance of payroll reporting and no FUTA, SUTA, Social Security and Medicare payroll taxes, No worker’s compensation insurance and avoiding costly employee fringe benefits such as group hospitalization. And last but not least, no coverage under various federal laws such as OSHA, anti-discrimination and minimum wage and hour laws.
Thus a strong motivation for wanting to treat employees as independent contractors.
But what happens when the IRS conducts an audit and determines that the independent contractors are actually employees?
What happens is ugly. To illustrate the impact assume two individuals who were paid $50,000 each as independent contractors and are later determined to be employees.
The $100,000 paid is payroll and IRS assesses the employer share of social security and medicare taxes, total $7,650. The IRS assesses a similar amount for the employee share for a new total of $15,300. Penalties ranging from 1.5% to 3% are assessed for failure to withhold income tax, $3,000 in this case- new total of $18,300. Penalties ranging from 20% to 40% of the employees share of Fica taxes are assessed for failure to withhold the Fica tax, amount of $3,060, new total of $21,360. Then the icing on the cake, the IRS can go back five years in addition to the current year. Assuming prior years to be comparable, the new total tax and penalties assessed is $128,160 ($21,360 x 6). The net result is that the IRS might put the company out of business.
What can you do to minimize exposure?
First and foremost treat all workers doing the same job the same way and be consistent from year to year. Do not change anyone that was an employee to independent contractor status. Prepare Forms 1099-Misc for all independent contractors and timely file and provide copies to the individuals. Make sure that independent contractors do not participate in any group health, life or dental plans, cafeteria or retirement plans, vacation sick, severance pay or other employee fringe benefit programs, and even incidental ones such as auto reimbursement or cell phone privileges. Do not provide tools, vehicles, or supplies incidental to the job. Do not make loans or advances to independent contractors. Keep their records in files independent of those maintained for employees and have and keep a copy of the independent contractor agreement, Forms W-9, bids, and workers compensation certificates provided by independent contractors within those files.
Most importantly- Have an attorney prepare a written agreement to be used for all independent contractors, and include a copy in the entity’s minutes. The agreement should stipulate that the independent contractor is responsible for all income and payroll taxes in connection with amounts paid for services. It should specifically mention that the worker will not be treated as an employee for federal tax purposes and not be entitled to any fringe benefits normally available to employees. Stipulate that the worker needs to provide workers compensation and other insurance if required, and to secure business licenses as necessary. After drafting the agreement you need to brainstorm together with your attorney and create a rationale for treating workers as independent contractors. In this regard look toward the Internal Revenue Service website (Specifically, http://www.irs.gov/businesses/small/article/0,,id=99921,00.html) for the items that the IRS uses to determine employee status. Indicate in the minutes associated with the independent contractor agreement the items that would apply as rationale. Don’t forget that long standing industry and competitor practices in the area may apply and can be of benefit. Document as many points as possible in the minutes to provide the rationale for independent contractor status.
While there is no guarantee that following the above guidelines will in itself mitigate the IRS’s position that you have employees and not independent contractors, there is a more likely than not chance that following the above suggestions will result in the IRS only assessing the year under audit (if at all) and not looking back the prior five years. We strongly urge that you address these issues as soon as possible if you are treating workers as independent contractors. Above all if you truly have employees and not independent contractors we urge that you make the conversion and put them on payroll as soon as possible.
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