Heading off an IRS audit - classifying workers as independent contractors - includes related article

Nation's Business, March, 1996 by Jennifer Haupt

If you classify any workers as independent contractors, make sure you're prepared for an IRS compliance check.

When the Internal Revenue Service notified Barbara Rutledge that it was checking her firm's compliance with employment-tax rules, she wasn't wonted. Her company was using both independent contractors--who are responsible for paying their own payroll taxes--and employees, and she thought she had complied carefully with the regulations that distinguish between the two classes of workers.

"I ran my business to the letter of the law, always filed 1099s [forms reporting the amount paid to a contractor], and figured I had nothing to hide," says Rutledge. At the time, she was president of Apollo Drywall, a Lansing, Mich., firm that she later had to dismantle because of the toll that her battle with the IRS took on her finances and her health, she says.

It wasn't until after Rutledge and her accountant had been questioned by an IRS agent for three hours that she started to worry. "The notice had stated the IRS wanted to review my tax forms, but the auditor asked me all sorts of detailed questions that I didn't expect and wasn't prepared to answer," says Rutledge.

Apollo Drywall subsequently was audited based on Rutledge's answers to IRS Form SS-8, which employers must complete during a compliance check or tax audit. The form is used by the IRS to determine if a worker is an employee or an independent contractor. Apollo Drywall was assessed $26,112 in back taxes and penalties for having misclassified workers as independent contractors in 1987 and 1988.

Four years later, a federal court ruled Rutledge was entitled to a full retired of the tax assessment and two-thirds of the $23,000 she had spent for attorneys' fees. But her lawyer, Patrick Hanes, a partner in the Lansing firm of Howard & Howard, says Ruff edge could have avoided a lot of expense and aggravation--and possibly the audit--if she had been better prepared for the compliance check.

"The biggest mistake business owners make is taking the compliance check too lightly," says Hanes. "This is the point where you need to arm yourself with proof that workers are independent contractors, and [you need to have] thought-out answers to the SS-8 form." Being called for an audit, he says, usually means "the IRS has already decided you've done something wrong."

At issue is the long-standing feud between small business and the IRS over just how to define an independent contractor. (See "Shaky Declarations of Independence," December 1995.) Last June, participants in the White House Conference on Small Business voted as their No. 1 concern the establishment of a clear-cut standard for determining who is or is not an independent contractor.

The IRS estimates that more than half of the roughly 5 million Americans now working as independent contractors should be reclassified as employees. As such, their employers would have to withhold payroll taxes--Social Security, Medicare, and unemployment-insurance taxes--and forward them to the IRS.

In contrast, an employer who uses an independent contractor is required only to send the IRS a Form 1099, which reports the amount paid by the company to the independent contractor. It's then up to the contractor to pay all taxes directly to the IRS.

The agency contends that 60 to 70 percent of all independent contractors don't pay their taxes, costing the federal government up to $4 billion annually in lost revenue.

To identify misclassified workers, the IRS in 1988 launched the Employment Tax Examination Program, or ETEP. Through 1994, the IRS had completed 11,380 ETEP audits, resulting in the reclassification of 483,000 workers who had been regarded as independent contractors. As of November 1995, the IRS had recommended an additional $941 million in taxes since the inception of ETEP, although much of that amount is being appealed by business owners.

Among the standards that the IRS can apply to differentiate between employees and independent contractors is a 20-point test that an IRS agent administers during the ETEP audit. (For the 20 points, see the box on Page 44.)

"You get the sense walking into an audit that they're going to find at least one of the 20 points not in your favor," says Barry Frank, a Philadelphia tax attorney who specializes in disputes with the IRS over the use of independent contractors. He says some auditors have told him "there's no such thing as an independent contractor."

To head off an audit--and the bill for back taxes that usually follows--make your case convincingly at the compliance-check stage. Here are some suggestions from experts:

Be Careful About What You Say

Tax attorneys and accountants frequently advise small-business clients not to speak directly with an IRS auditor. A compliance check consists of a perusal of your IRS employment forms for the year or years in question and a brief interview going over your knowledge of and compliance with the 20 common-law guidelines.

"People get very nervous when talking to the IRS and don't know when to be quiet," says Howard Rosenbloom, an accountant with Shubitz, Rosenbloom, Lustig, Lustig & Co., in Miami. "When a simple yes or no will do, they go into a whole explanation of all kinds of things that the agent doesn't need to--or want to--hear." Almost always, he says, "I answer auditors' questions with 'Here are my client's records.'"