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How to Correctly Classify Workers and Avoid IRS Employment Tax Audits

How to Correctly Classify Workers and Avoid IRS Employment Tax Audits

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Published by Michael Rozbruch
Employers must beware of the federal and state crackdowns on the use of independent contractors to avoid payroll tax problems and employment tax audits. But how do you distinguish between independent contractors and employees? More importantly, how does the IRS determine who owes unpaid employment taxes and who doesn’t? Consider these tips to make correct determinations of worker classifications and avoid the wrath of IRS audits for unpaid employment back taxes and payroll tax problems.
Employers must beware of the federal and state crackdowns on the use of independent contractors to avoid payroll tax problems and employment tax audits. But how do you distinguish between independent contractors and employees? More importantly, how does the IRS determine who owes unpaid employment taxes and who doesn’t? Consider these tips to make correct determinations of worker classifications and avoid the wrath of IRS audits for unpaid employment back taxes and payroll tax problems.

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Published by: Michael Rozbruch on Oct 29, 2010
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11/01/2010

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Employee vs. Independent Contractor
 – 
How to Correctly Classify Workers and Avoid IRSEmployment Tax Audits
 
 Employers must beware of the federal and state crackdowns on the use of independent contractors to avoid payroll tax problems and employment tax audits. But how do youdistinguish between independent contractors and employees? More importantly, how does the
 IRS determine who owes unpaid employment taxes and who doesn’t?
Consider these tips to makecorrect determinations of worker classifications and avoid the wrath of IRS audits for unpaid employment  back taxes and payroll tax problems.
Business audits are on the rise as the treasury needs every penny of  unpaid employment taxes 
it’s
 
owed. While some companies deliberately misclassify their workers in order to escape offeringhealth insurance and 401K plans to their employees, somebusiness ownersare flat out confusedas to how to correctly classify their employees. How do you distinguish between independentcontractors and employees? More importantly, how does the IRS determine who owes unpaid
employment taxes and who doesn’t?
 
There’s a 20
-point common law test, internal revenue code section 5-30, that determines whethera person is an employee or an independent contractor. So even though you may be treating aperson as an independent contractor, in the eyes of the IRS and the 20-point common law test,that may not be the case. When making determinations of worker classifications, consider thefollowing:
Tip #1 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes:
Ask yourself, “Who’s in charge?”
 In business audits, the IRS uses three general criteria to determine the relationship betweencompanies and workers:
 
Behavioral Control - does the business direct or control how the work is done and whathours the employee works?
 
Financial Control - does the business direct or control the financial and business aspectsof the worker?
 
Type of Relationship - how do the worker and business owner perceive their relationship?The employment tax audit bottom line - if the company is determining only what work is done, their workers are probably independent contractors. On the other hand, if they control not only
 
6345 Balboa Blvd, Suite 285Encino, CA 91316Phone: (866) IRS-PROBLEMS or(818) 774-1813Fax: (818) 774-9361Web: www.taxresolution.com
 
what is done, but how it is done (when, where, etc.), then the workers are probably employees.
Tip #2 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes:Determine where the buck stops.
 What risk of loss does the worker have? Do they pay for and use their own tools (computer,printer, high-speed, etc.), or do you provide them with what they need? When it comes toemployment tax audits, the worker carrying theliabilityis an independent contractor.
Tip #3 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes:
 
Check the name on the check.
 To avoid unpaid employment taxes, discover if your accounting department is writing checks to
“Jane Doe” or “Jane Doe, Inc.” If 
the worker is doing business under a DBA fictitious businessname, LLC or other organizational umbrella, an employment tax audit would most likely declare
 
that person a contractor.
Tip #4 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes:Ask them to sign an exclusivity agreement.
 
 
Most independent contractors juggle many clients at a time. If your worker refuses to sign anexclusivity agreement, they are likely working for other companies and consider themselves freeagents. An employment tax audit or business audit would consider them an independentcontractor.
Tip #5 for Avoiding Employment Tax Audits for Unpaid Employment or Payroll Taxes:Ask whether they want a W-2 or 1099.
 
If you’re in need for  
tax relief  the best defense against unpaid employment taxes is in thepaperwork. An experienced independent contractor will ask for a 1099 form and pay their owntaxes to avoid payroll tax problems
.If you’re hiring an independent contractor for the first time,
 
it is incumbent upon you to ensure that they know what their responsibilities are and avoidunpaid employment taxes.Imagine this nightmare scenario: At some point in the future, a former worker of yours applies tothe state for unemployment compensation. If no one has ever filed wages for that person, theymay be forced to ask,
“What is that about? I worked there 9 to 5, 40 hours a week, and they gaveme an hour for lunch. I worked for them.” At that point,
as a business owner your payroll taxproblems have just spiraled out of control. The state unemployment compensation board is goingto notify the state Department of Revenue of your possible unpaid employment taxes and audityour business. In 22 states this will quickly be followed by a knock on the door from the IRS anda federal business audit.  However, if you can show them a signed agreement where the worker acknowledged their rights
and responsibilities as an independent contractor, you’re going to save yourself 
the hugeheadache of unpaid employment taxes or payroll tax problems,a business audit and the possible
 
shut-down of your business.

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