May 20th, 2011

Some of you may be aware that as a business owner, you can save thousands to tens of thousands of dollars each year in taxes and benefits by hiring independent contractors rather than employees.

As an employer, you can avoid the paying, withholding, and filing costs each and every year for your independent contractors that you would otherwise need to incur with an employee.

It should come as no surprise to you that the IRS has been working hard to close this amazing loophole as part of its efforts to raise tax revenue.

IRS Very Aggressive on Closing This Legal Taxloophole

I met a man who owned a mortgage company and paid all his sales people as independent contractors. He got under a brutal IRS audit and ended up losing EVERYTHING…  his business, his investments, and his home. Needless to say, the IRS will continue to enforce this area of the tax code because it is a high revenue generator for the Treasury Department.

So what does this mean for you as a business owner? This means that you need to protect Yourself! If you have independent contractors in your business, you need to make sure you have all the correct documentation and support protect yourself in case of an audit.

How to Protect Yourself and Strengthen Your Position

In order to protect your business from the auditor, you first need to know “how” they conduct their audits in this area.

Currently, the IRS agents take a special class that trains them on how to audit worker classification of small businesses.

The good news is that the materials in this auditor training course are actually available for us to see! We can all access the IRS playbook and learn about “how” they plan to audit our businesses! This manual, entitled “Independent Contractor or Employee?”, is available at www.irs.gov/pub/irs-utl/emporind.pdf.

Bottom Line 7 Critical Audit Factors from IRS’s 160-page Training Guide

If you aren’t too excited about reading through all 160 pages of the manual, you are in luck. Here is a highlight of only the important areas that you need to know.

The auditors are taught to analyze the employee versus independent contractor status of your workers using a series of seven factors. These factors are:

  1. Degree of control exercised by the principal.
  2. The worker’s investment in facilities.
  3. The opportunity of the worker for profit and loss.
  4. The right of discharge.
  5. Whether the services performed were part of the principal’s regular business.
  6. The permanency of the relationship.
  7. The intent of the parties.

In addition, the auditors focus on the dynamics between the employer and the worker in terms of behavioral control, financial control and relationship of the parties.

In short, the IRS wants business owners to have little or no control in the behavior and finances of its workers in order to be an independent contractor. The more financial and behavioral control the employer has, the more likely the relationship is one of employer/employee.

As an example, a truck driver for a delivery company was able to qualify as an independent contractor and not an employee because the truck driver:

  1. Controlled the manner in which he scheduled pickups and deliveries.
  2. Invested a significant amount of money in his truck driving activity.
  3. Bore the risk of loss if his trucking expenses exceeded his income

Now that you know “how ” the IRS looks at the independent contractor status in doing their audits, here are 4 things you can put in place to protect yourself in case of an audit:

  1. Create a job description for the position which indicate limited control and an independent working environment
  2. Ensure your Company’s operating agreement and employment policies treat the position as an independent contractor
  3. Get a signed independent contractor’s agreement between the Company and the worker
  4. Have a completed Form W-9 from each independent contractor you hire

As we discussed, the independent contractor is a great way to cost efficiently add to your workforce. Savings in money and resources can make hiring independent contractors an attractive alternative to hiring employees. Now that you know IRS playbook, you are armed with the strategies that can help you to safely maneuver potential future audits.