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Gearing up for an IRS employment tax audit: Employee Misclassification

Beginning this month, the Internal Revenue Service (IRS) will launch a major audit initiative focusing on the underpayment of employment taxes by employers. Part of its Employment Tax National Research Project (NRP) — the IRS will randomly select 2,000 employers to audit each year for the next three years. These employers will be subjected to comprehensive audits of their employment tax practices. "The results of the audits will allow the IRS to gauge more accurately the extent to which businesses properly comply with employment tax law and related reporting requirements," said the agency. "When completed, this information will help the IRS select and audit future employment tax returns with the greatest compliance risk."

The IRS began the NRP in 2000 to measure the so-called tax gap — the gap between taxes voluntarily reported by taxpayers and the amounts actually due to the IRS. Past NRP projects have focused on audits of randomly selected individuals and S corporations. The IRS Advisory Council also recommended that the IRS utilize the NRP to explore employment tax and independent contractor issues.

The NRP project will focus on four areas that the IRS believes currently are improperly reported by employers:

(1) Worker classification (employee vs. independent contractor);

(2) Fringe benefits;

(3) Executive compensation; and

(4) Reimbursed expenses

Of particular interest to employers is worker classification because misclassification can have a host of consequences. Classifying employees incorrectly as independent contractors can impact minimum wage and overtime requirements, income and employment tax collections, pension and health benefits, employment discrimination, employee safety and health protections, Social Security retirement benefits and unemployment insurance. The national extent of employee misclassification is unknown. However, studies suggest that it could be a significant problem with adverse consequences.

With respect to worker misclassification issues, don't wait for an employment tax audit; pre-test your company's independent contractors to see if they meet IRS standards for independent contractor status. Misclassification can be costly — even if it's an innocent mistake. But the quicker the error can be rectified, the better off your company will be.

The best way to avoid worker classification errors is to develop a clear understanding of all the factors that determine a worker's status as an independent contractor.

Employers selected for an NRP audit will be notified by letter. There will be a designation with the letter indicating that it's not a routine payroll tax examination — it is an NRP examination. Selection for an NRP audit is not necessarily an indication that there's something wrong with a return. An NRP audit may not result in any changes — or any additional tax. Unlike routine employment tax audits that may be triggered by questions about your company's returns, returns are being selected for NRP audit on the basis of statistical sampling. It's simply the luck of the draw.

The cost of worker misclassification. If the IRS decides that a company's independent contractors should have been classified as employees, the company must be prepared to pay a price. As a general rule, this "price" includes both the employer's share of FICA taxes and the income and FICA taxes that were not withheld from the employee's earnings.

Should you have questions about distinguishing between employees and independent contractors, you may contact SESCO at 423-764-4127 or by email at