IRS Hot Button Issue: Worker Classification

We recently contributed to a Birmingham Business Journal article (subscription required) detailing the increase in IRS audits of individual taxpayers. Business audits are on the rise as well. While general income tax audits will continue to be commonplace, the IRS is increasingly targeting specific areas of noncompliance. One such area is worker classification.

The worker classification issue centers on whether a worker is an employee subject to Social Security, Medicare, and income tax withholding or an independent contractor for which a business generally has no tax withholding responsibility. There is no bright-line test for businesses to follow in making this determination, only general guidelines relating to the extent to which a business controls the means and methods by which a result is accomplished. Greater control generally favors an employee classification whereas lesser control generally favors an independent contractor classification.

Many businesses wish to push the tax compliance burden on their workers, thus classifying them as independent contractors without considering the control element that should govern this classification; however, businesses do so at their own risk. The IRS’s bias is toward classifying workers as employees, which it believes results in more accurate and reliable payment of employment taxes.

In order to clamp down on perceived errors and abuses relating to worker classification, the IRS announced last year a three-year plan to audit 6,000 businesses for employment tax compliance. While these audits will target the entirety of employment tax compliance, it is believed that the greatest tax revenue potential lies in the misclassification of workers.