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Q & A: independent contractors

The IRS and many state agencies have stepped up their oversight of independent contractors and not just in the construction industry.

Q. “I understand the IRS has a three-prong test to determine whether an individual should be classified as an employee or an independent contractor. How many of these factors have to apply to be properly classified as an independent contractor?”

A. There is no magic threshold or number. Decisions are made on a case-by-case basis. The IRS looks at behavioral control, financial control and the relationships of parties. This three-prong test groups together the prominent factors in what was once referred to as the “Twenty Factor” test. Classification depends on the particular facts and circumstances of each case and often there is no clear-cut answer. There are many gray areas and if in doubt it is best to seek legal counsel or request an IRS determination by using form SS-8.

Q. “If there is a written contract describing the individual as an independent contractor, isn’t that sufficient?”

A. No. While a well-drafted legal agreement that defines a true independent contractor relationship will help, if the implementation of the agreement does not meet the criteria for classification as an independent contractor, the contract will not be sufficient. If a company incorrectly classifies an employment relationship, the costs can be substantial. That company may end up having to pay uncollected payroll and income taxes, interest and penalties on workers they never considered to be employees. For a business that incorrectly assumes the existence of an independent contractor relationship, the risks increase proportionately as time passes.

When the individual is a bona fide independent contractor, it’s important that the contract include statements that the independent contractor will not receive fringe benefits and describe the independent contractor’s responsibility for maintaining and paying for the required insurance, including Workers’ Compensation.

Q. “Why is there so much focus on this issue now?”

A. Federal and state governments facing record budget deficits are aggressively pursing companies that try to save money by classifying employees as independent contractors. The 2010 budget assumes that the federal crackdown will yield at least $7 billion over 10 years. The Labor Department estimates that up to 30% of employers misclassify independent contractors. Among the most often misclassified workers are truck drivers, construction workers, home health aides and high-tech engineers.

Starting in February 2010, IRS officials will conduct random audits of approximately 6,000 U.S. businesses. These random audits are intended to help close the estimated $15 billion “tax gap” that the U.S. Government Accountability Office (GAO) believes is attributed to workers being misclassified as independent contractors versus company employees.

The IRS will also be reviewing for the proper issuance of Form 1099-Misc for any workers classified as independent contractors. It is suggested that prudent employers should review the classification and documentation maintained for any “independent contractors” associated with their business.

The Obama administration also plans to rewrite a three-decade-old I.R.S. rule that lets companies indefinitely classify employees as independent contractors — even when the government knows they are misclassified — so long as the company once had a reasonable belief that the workers were contractors.