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It’s no secret that the federal government is in need of money. With the national deficit expanding daily and the country in the midst of an economic recession, Uncle Sam is looking for ways in which to fill his coffers.

If you make contract placements and run your own back-office, one of those ways might involve levying fines and penalties against your firm because of several government initiatives. Specifically, the Internal Revenue Service believes that it is losing billions of dollars because workers are being misclassified as 1099 independent contractors instead of W-2 employees.

How much money are we talking about? In 2007 alone (2008 data is not yet available), the Government Accountability Office estimated that worker misclassification cost the federal government a total of $4.7 billion in income taxes. As you can imagine, when the IRS believes it’s losing that much money each and every year, it’s going to do something to recoup it.

The IRS and its initiatives
What should be of most interest is the fact that the IRS is stepping up its efforts to uncover the more than $4 billion it’s losing each year due to the misclassification of workers. The agency is attacking this financial loss from a number of different angles and through multiple channels.

First and foremost, the IRS is sharing information with other agencies, among them the U.S. Department of Labor, to determine if overtime, minimum wage, or prevailing wage laws are being followed.

Second, the IRS is now working more closely with state agencies that administer taxes. Employers that are found to have violated state labor laws may be required to pay back taxes, back wages, unpaid workers’ compensation premiums, and unemployment premiums. Many states are cooperating fully with the IRS on this issue and have been extremely proactive in their efforts to uncover misclassification. In fact, several states have made worker misclassification a priority and are imposing even more severe penalties in response to any wrongdoing.

Since the inception of this initiative, the Department of Labor and the Government Accountability Office have been strongly encouraging the participation of every state agency. It’s only a matter of time before every state is a full and active participant and is exchanging information with the IRS for the purposes of identifying—and ultimately punishing—wrongdoing in the area of employment taxes.

A further illustration of the growing relationship between the IRS and other agencies is the Questionable Employment Tax Practices (QETP) initiative, which is designed to uncover employment tax schemes that have objectives other than to avoid federal and/or state employment taxes. The key element of this initiative is the exchange of important information between the IRS and state agencies. Specifically, they will exchange audit reports and audit plans, and they will also conduct side-by-side examinations of data, if it is deemed to be appropriate.

In addition, an IRS National Research Program (NRP) regarding employment taxes is currently in development and will be initiated in November. The stated goal of the NRP is “to collect data that will help the IRS improve its compliance programs and better use its resources.” Once the NRP is started, IRS officials will conduct detailed examinations of taxpayers they believe are worthy of such scrutiny. The primary focus of the NRP initiative is the issue of worker classification. The other three areas of focus are fringe benefits, officers’ compensation, and reimbursed expenses. During a time when executive bonuses are receiving so much attention in the media, it’s striking to note that the IRS considers worker classification a bigger issue.

Along with the aforementioned, the IRS utilizes other measures to help detect misclassification of workers, as well. Those measures are as follows:

1. The 1099 Matching Program—This program targets those individuals who only file one Form 1099 with their personal tax return. (A person receiving payments from just one company is more likely to be an employee rather than an independent contractor.)

2. The Employment Tax Examination Program—Under this program, the IRS assigns revenue examiners to focus on companies suspected of worker misclassification.

3. The IRS also uses its customary audit routine to detect improprieties.

How should you classify workers?
Now let’s take a look at how the IRS says you should classify workers. In 1987, the agency published a 20-Factor Test to help businesses determine whether or not a worker was a common law employee. However, nine years later the IRS restructured the test into three main categories—behavioral control, financial control, and type of relationship. According to the website, “The determination is complex, but is essentially made by examining the right to control how, when, and where the person performs services.”

Clarification on the three main criteria for determining worker classification is listed below:

1. Behavioral control—Facts that show whether the company directs and controls (or has the right to direct and control) how the worker performs the task, including training, and instructions about when, where, and how to provide the service

2. Financial control—Determined by analysis of the facts that demonstrate the company controls or has a right to control the economic aspects of the worker’s job, including whether the worker (1) has unreimbursed expenses, (2) has an investment in tools or facilities, (3) works for more than one company at the same time, (4) is paid by the job or hour, or (5) can suffer a loss by taking the work

3. Type of relationship—Facts showing the tie between the parties, including (1) written contracts, (2) whether the worker receives benefits, (3) the duration of the work, and (4) extent to which the services are an aspect of the company’s regular operations

If you make contract placements and run your own back-office, you should be using these parameters to determine whether or not your workers are classified as 1099 independent contractors or as W-2 employees. But you also have another option. The IRS will determine whether services are performed as an employee or independent contractor if you submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. To access this form, go to

Case study: a real ‘audit nightmare’
A recruiter named John was kind enough to share his IRS audit nightmare with us. In his case, he had been qualifying 1099 independent contractors according to IRS guidelines for years and was very familiar with the 20-Factor Test and the three main criteria for worker classification (behavior control, financial control, and type of relationship). In addition, he had one of the top CPA firms in his state handling his business.

Last year, John had a situation where a contractor worked through his recruiting agency as a W-2 employee, and then the same contractor became incorporated and insisted on switching to a 1099 status. John agreed because she (the contractor) provided LLC paperwork and supporting documentation. Everything seemed to be continuing as normal until the client ended her contract assignment earlier than expected. Believe it or not, she filed for unemployment benefits and said that John’s company was her employer. (This was not the case once she converted to a 1099 status.) The unemployment issue sent up a red flag to the state unemployment agency, the state agency notified the IRS, and when the IRS came to collect taxes from her, she said she was an employee and not an independent contractor. (Sometimes workers can be fickle.)

The next thing he knew, John was contacted by the IRS Auditor! The IRS audit disrupted his business for three months, cost him about $10,000 in back taxes, and he had to pay a huge fee to his CPA firm for coordinating the audit. It was a nightmare, and he was really helpless to do anything about it. In John’s case, though, he was lucky. He could prove that the worker misclassification was unintentional, and he actually got off easy with the IRS.

Fines, penalties, and your reputation
While we’ve already touched briefly on some of the penalties, it’s crucial to note that those companies found to have misclassified workers will be penalized at both the state and the federal level. It’s not an either/or proposition; it’s definitely both.

Penalties for misclassifying workers fall into two categories. These depend upon whether or not the misclassification was unintentional or intentional. If it’s determined that an employer intentionally misclassified a worker or workers, then the employer is liable for the full amount of federal income tax that should have been withheld, as well as 100% of the employee’s and employer’s share of Social Security and Medicare taxes. (Keep in mind that there will also be other penalties and fines levied that you might owe the IRS for failure to file returns and pay taxes that may require IRS levy help.)

The bottom line is this: don’t mess with the IRS! All it takes is one mistake in classifying a worker, and you could be subject to a lengthy audit, followed by fines and penalties. In addition to the money, your reputation as a recruiting firm is on the line. It’s inevitable that your clients will be drawn into the IRS audit in one way or another.

If you’re classifying workers as 1099 independent contractors instead of W-2 employees, take the time to carefully analyze the IRS’s guidelines and review their initiatives. It may be time to remedy the situation.

FoxHire has been the recruiter’s back-office solution for over 17 years. We’re up-to-date and compliant in all federal and state guidelines, including the issue of worker classification. (We underwent a routine employment tax audit recently and received a “no change” report, noting that the worker classification issue was specifically raised by the auditor, everything was accurate, and no changes were required.) Consider using our back-office for your contract placements and allow us to handle all of the legal, financial and administrative issues. Plus, you won’t have to worry about compliance.

(Note: This newsletter is intended to give general information only and should not be construed as legal advice for specific situations. Please contact your legal counsel before taking any action.)

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