The feds use legal analysis to determine if a worker is on staff or a freelancer.

If your business uses independent contractors in place of employees, the Internal Revenue Service could be watching you. For years the IRS has battled with employers regarding the classification of workers as either independent contractors or employees. In order to increase compliance with tax law and to raise revenue, both the IRS and various states are renewing efforts to challenge businesses whose workers are classified as independent contractors.

IRS reclassification of workers as employees can be an expensive proposition, as the employer can be held liable for back payroll taxes, penalties, and interest.    

There are many reasons that a business may choose to use independent contractors. Typically, the most common reasons are to avoid having to pay payroll taxes and provide benefits to workers. However, the law does not permit employers to elect between independent contractor and employee status. Whether a worker is an employee or an independent contractor depends upon a legal analysis.

Under the law, the IRS considers the degree of control that the employer has over the worker. It looks at three specific categories of factors: behavioral factors, financial factors, and contractual relationships.

First, the IRS asks whether the employer controls or has the right to control what the worker does and how the worker does his or her job. It considers whether the employer decides who is to assist with particular work, where supplies are purchased, and the order or sequence of when work is to be performed. The more control that the employer exercises over the worker, the more likely it is that the worker is an employee.

Next, the IRS considers whether the employer controls the business aspects of the worker's job. The service considers the worker's circumstances to determine whether the worker has made a significant investment in the business, whether the worker has unreimbursed expenses, and most importantly, whether the worker is in a position to have an opportunity for profit or risk of loss. Having the possibility of incurring a loss indicates that the worker is an independent contractor. If the worker is paid a regular guaranteed wage, the worker is likely an employee.

Finally, the IRS looks at the relationship between employer and worker. It will consider any written contracts, but merely calling someone an independent contractor in a written contract is not sufficient. It wants to know whether the relationship is temporary or permanent and whether work performed by the worker is a key aspect of the employer's business. If it is, the worker is probably an employee.

If you apply the IRS analysis to your own circumstances, you might come to the conclusion that the IRS might classify some of your independent contractors as employees. Even so, you may still have the right to treat these individuals as independent contractors.

Back in 1978, Congress became concerned that the IRS was unfairly attacking businesses over the independent contractor issue. Thus, it passed Section 530 as part of the 1978 Revenue Act. Section 530 prohibits the Internal Revenue Service from retroactively reclassifying "independent contractors" as employees if the employer:

1. consistently treated the workers (and similarly situated workers) as independent contractors;
2. complied with Form 1099 reporting requirements with respect to compensation paid to those workers; and
3. had a reasonable basis for treating the workers as independent contractors.

In order to have a "reasonable basis" for treating someone as an independent contractor, the employer must base its decision on a judicial or administrative ruling, a prior tax audit that did not challenge the classification of the workers, industry custom, or some other reasonable basis.

Recently, the IRS announced the creation of the Voluntary Classification Settlement Program (VCSP). Under VCSP, the IRS allows an employer to voluntarily reclassify its workers as employees for future tax periods for employment tax purposes. In order to obtain relief, the employer is obligated to pay 10 percent of the amount of employment taxes for the compensation paid for the most recent tax year to the workers being reclassified under the VCSP. In addition, the employer will not be liable for any interest and penalties on the payment under the VCSP, and will not be audited for employment tax purposes for prior years with respect to the worker classification of the workers.

The response to this voluntary program has been lukewarm. Depending upon the number of workers subject to reclassification, the prior year employment tax amount can be rather significant. Additionally, employers are concerned that voluntarily agreeing to reclassification with the IRS exposes them to possible back taxes, penalties, and interest with respect to state employment-tax obligations.

Michael P. Coyne is a founding partner of the law firm Waldheger Coyne, located in Cleveland, OH. For more information of the firm, visit: www.healthlaw.com or call 440.835.0600.