Employee vs Independent Contractor Audits

This company represents trucking construction trades, and other small to mid-sized businesses. In IRS examinations, among the top 3 most common areas we see for audit is the legal question of whether workers/drivers are independent contractors, or simply employees.

Employees’ wages are reported to the federal and state governments on the Form W-2, Wage and Tax Statement. On this Form W-2, a hiring company reports the employee’ earnings, as well as multiple taxes withheld by company. Independent contractors are instead reported on Form 1099-MISC, Miscellaneous Income. Workers’ and drivers’ incomes are reported but, generally, that persons’ tax reporting by the company is simplified. Often, there is no tax withheld.

Keep in mind that the difference has a substantial effect on the business that hires the workers. The tax effect is often so extreme, that it can force companies to close for business.

IRS Audits Are Selected to Increase Tax

The Internal Revenue Service communicates that it only wants to assess the correct amount of tax. But this statement is misleading. It is misleading because IRS does not seek to ever decrease anyone’s taxes, even if the decrease would be the corrected amount.

IRS audits are selected based on numerous different criteria. However, these criteria are designed to choose tax returns that likely have under reported tax. In short, IRS audits only intend to assess an increased amount of tax.

Why IRS Wants Contractors Considered to be Employees

When the legal issue of “Independent Contractor or Employee” is identified in audit, IRS has a preference. The government can assess more tax, and more easily collect tax, if workers are treated as employees instead of contractors.

To be clear, you should understand this audit issue as a “one-way street”. IRS seeks to treat Form 1099 contracted drivers as employees. The government rarely has an interest in treating people as independent contractors, when they were already reported by their companies as employees.

When “Independent contractors” appears as an item within a business tax return, IRS finds this an opportunity to increase tax to the hiring business.

Why Was My Company Selected For an Employment Audit?

There are many “indicators” that IRS will use to identify a company for tax examination. However, for an employment tax audit (i.e. audit where employees or contractor status is reviewed), there are primarily these indicators.

  1. Does the company that mainly employs contractors, operate within an industry where workers are more likely to fit the legal classification of employees?
  2. Among these workers whose earnings were reported on Form 1099-MISC, did they all file tax returns, report their earnings, and pay their taxes?

Each of these indicators the government justifies in different ways. However, the end process is the same. That process seeks to apply the common law rules of controlling the independence to determine status of employees. Then the government uses administrative ease, by requiring the hiring company collect and pay tax, and even share in the burden of paying employment taxes.

Example: A Wheaton, Illinois area trucking company hires 20 drivers, and pays them all as contractors. The company appropriately reports the drivers’ earnings on Form 1099-Misc. However, the company is then contacted by someone in IRS’s Downers Grove (Illinois) office, and seeks to examine the company’s tax returns. Several of the items specifically requested by IRS are the company’s:

  • Payroll records
  • Policies and procedures on hiring drivers
  • Driver training given by the company
  • Driver identities, contracts, work schedules, etc

In cases like these, the IRS attempt to gather information on how to make a determination that these drivers should be classified as employees, not independent contractors. In these type of cases, the company should be very cautious, and to protect itself within the audit.