In February last year the Internal Revenue Service began its three-year National Research Program of small-business audits, which will audit 2,000 small businesses per year. The sample is selected at random, and the results, according to the website of the American Bar Association, are intended “to provide the IRS with a statistical sample of overall employment tax compliance.”
STATES MORE ACTIVE It's not just the IRS that's interested in how you classify workers. According to the National Association of Professionally Accredited Contractors (NAPAC, www.napac.net), 13 states have passed legislation rewriting or tightening up employee classification rules. Should your business get hit with a reclassification audit, you could be liable for payroll taxes, Medicare, and Social Security contributions, back workers' comp, and more.
NAPAC general counsel D.S. Berenson, of Johanson Berenson LLP, says that an even greater risk is the threat of a class action suit arising from that audit. He suggests companies require that the independent contractors they use be organized as entities and that they maintain a detailed compliance file on each. To successfully defend your classification, that file should include protocols such as proof of: licensing (in states that require it), insurance coverage, workers' comp, corporate status, and tax filings. Companies that maintain such legally approved files, Berenson says, have an almost 100% chance of surviving a reclassification audit in the majority of circumstances.
WHAT YOU DO, NOT WHAT YOU SAY IRS auditors use a series of 20 factors that determine if the worker is a W-2 or 1099 employee. Among the most important are method of payment, continuity of the relationship, and whether you provide fringe benefits such as health insurance.
Ambiguity abounds. For instance, Berenson says that allowing a salesperson who is an independent contractor to participate in your company's insurance plan — with you deducting payments from commission checks — could be considered completely valid and not a reason to define that salesperson as an employee.