Routine Payroll audits are conducted each year by the IRS and State revenue agencies to primarily determine if independent contractors should be reclassified as employees. But according to the Wall Street Journal not only is the IRS increasing their “crackdown” on small business, but “more small businesses are finding that independent contractors are essential to remaining competitive.” WSJ March 14, 2013.
So how do you make sure the IRS will find your independent contractors to be “independent” of your control and not employees?
First and foremost, longer term independent contractors need to have Federal ID #, a business address with a business trade name and be issued a 1099. That is not to say the Joe Smith the electrician who provides you with monthly maintenance service on your wiring has to go out and jump through all these hoops. But it would sure make a more convincing argument to the IRS if you should be unlucky enough to be audited. Also make sure Joe is licensed by the county or city. It surprises me how many small business owners fail to get a copy of the independent contractor’s business license. Go ahead and show the IRS Joe’s business license and watch the IRS agent smile saying very good. The license is particularly helpful when the audit takes place years later and Joe has long since left the area and cannot be located.
Furthermore, it sure helps your cause with the IRS if the independent contractor is not paid every two weeks with the same amount just like your payroll pays your employees. Require Joe to invoice you monthly just like all the other vendors on his stationery. Pay Joe the same time you pay all other vendors and issue the check payable to the business name and business address. Do not provide Joe a place to work, a desk or office space without a lease for space. In fact all independent contractors should ideally have written agreements with you the customer stating the scope of work, how they will be paid, and that the work is being performed by an independent contractor not an employee. There should be a paragraph in the contract that states the independent contractor has adequate insurance for his car, truck, equipment as well as liability insurance. In addition, if workers comp is required by state and Federal law, the independent contractor should provide evidence that he is covered and has covered any of his employees or workers. Finally keep a list of some of Joe’s present and past customers to prove to the IRS that your independent contractor was not earning all his income solely from you.
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Unfortunately, even if the IRS gives you a clean bill of health, if a state taxing authority audits after the IRS finishes up, there could be a very rapid change for the worse. That is due in many cases to unemployment compensation issues at the State level. For example, you have five long-term independent contractors working for you. One of your independents Martha suddenly gives you 30 days’ notice as required by the contract that you both signed. After the IRS cleared all your independents in a recent payroll audit you get a friendly state auditor knock on your door claiming that Martha had made a claim for unemployment insurance which you only now begin to remember. You had opposed the claim stating that Martha was not an employee, but states are sometimes inclined to give unemployment compensation to an independent who appears to have had a long-term relationship with the company and was under a certain degree of control. So in this case Martha was granted unemployment compensation. Sorry to say, unemployment compensation trumps everything. Now for the really sad part, the IRS then comes back and reclassified everyone performing similar duties based on this one unemployment case and the degree of control that you exercised over Martha.
Needless to say, this is a very complex area of law. Consult your CPA/Attorney for further advice, but don’t delay on this one. The IRS is charged with collecting tax revenue and they do a very good job at it. Be prepared and be ready.
