IRS Audit Rules: Independent Contractors vs. Employees
Myth: The Internal Revenue Service (IRS) website says that it sets Clear guidelines to help businesses decide if a worker should be classified as an independent contractor or an employee.
Debunked: The guidelines are not absolute. Every single case is unique, and does not neatly fit into the IRS’s standards. However, the guidelines are a good place to start.
IRS Audit Rules, IRS Tax Attorney (Naperville IL)
An independent contractor is supposed to be someone who works for a company but is not considered an employee. This is common in small businesses, especially in construction businesses, professional services, restaurants, and transportation. Instead of receiving wages with withheld taxes like employees, they are simply paid for the services they provide. However, the hiring company does not manage tax responsibility for the worker.
Why Does This Matter
Many companies prefer to treat their workers like “Contractors”. This way, those workers are responsible for paying their own taxes, including income tax and self-employment tax. The company does not have the responsibility to withhold taxes, and also for other payroll taxes.
For businesses, it is more affordable, plain and simple.
Worker classification is important because it affects whether, and how taxes are withheld, reported, and paid. However, misclassifying workers as contractors instead of employees can lead to audits. If an IRS audit determines that your workers were misclassified, your business could face back taxes and penalties.
By the way, Those penalties are in place of certain taxes. A determination of misclassification creates a serious amount of business expense, which cancels the intended affordability of the “independent contractor” classification.
Basic Worker Classification Guide to Survive the IRS Audit
To prove in an IRS audit whether someone qualifies as an independent contractor, the IRS looks at three main (key) factors:
1. Behavioral Control
Audit Test: How much control does the business have over how the work is done? The IRS presumes that if the company closely supervises tasks, dictates schedules, or gives specific instructions on how to complete the work, there is little (or no) worker independence.
Reality: When a company has more behavior control, the worker is more likely to be considered an employee. This is because independent contractors typically have the knowledge and freedom to decide how and when to complete their work, without direct supervision by the company.
For the Audit: Provide documents that the worker was already skilled in the tasks of the work. It helps to show proof of the worker’s training, prior experience, and control over his/her own schedule. An added bonus is to contrast the business’s lack of ability to supervise the workers. Also, compare the business owner’s skills against the worker’s unique skills in the job conducted. This does require some cooperation from the worker, so collect this information when the relationship begins, not when the audit happens.
2. Financial Control
Audit Test: How are the workers compensated, particularly considering whether they have a chance to make a profit or suffer a loss? Independent contractors often invest in their own tools, materials, or equipment. They might also have business expenses that employees typically don’t handle. Worker independence is more easily questioned when the company bears the financial burden of these expenses.
Reality: When a company bears more financial control, the worker is more likely to be considered an employee. This is because independent contractors typically bear some risk in their own business venture, which indicates a greater ability to incur a profit or loss.
For the Audit: Provide evidence of worker independence with items like the contractor’s:
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Special licensing
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Business creation and history
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Proof of insurance
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Marketing efforts and presence
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Business operation, location, support staff, etc.
3. Type of Relationship
Audit Test: What is the nature of the working relationship? Is there a written contract, and for how long? Are benefits like health insurance provided? Is the relationship ongoing, or does it end after a specific project? Contractors usually work temporarily or on a project basis without receiving employee benefits.
Reality: A worker more likely to self-provide (or provide to others) these conveniences and benefits is considered more independent. Also, even when the relationship is ongoing, but is on a job-to-job basis, suggests more independence.
For the Audit: Be prepared to show written contracts, including the terms of the contract. Especially provide terms of payment upon performance, penalties for failure to deliver, and written communications for either. Provide documents showing the worker’s form of compensation, which also indicates both the company’s and the worker’s expectations in the relationship.
Bonus Tip: The IRS or state auditor will not request these documents specifically. Having them prepared and organized for every contractor, before the audit, demonstrates a company that cares to maintain the independence of its work relationships properly.
By understanding these requirements, businesses can better plan to avoid negative results in IRS worker classification audits.