IRS audits take aim at independent contractors

Internal Revenue Service in black letters on white brick buildingLast month the IRS announced that over the next three years it will conduct 6,000 random audits of businesses that utilize independent contractors. With record numbers of Americans out of work and more than half the states borrowing from the federal government to pay unemployment claims, the motivation behind the crackdown is clear. According to, over the next 10 years, heightened enforcement of independent contractor rules could generate as much as $7 billion in extra cash from tax revenues.

Millions of misclassifications

An article posted on the BNET web site states that the IRS estimates that more than half of the approximately 5 million workers being paid as independent contractors should be reclassified as employees. MBO Partners, a business service firm specializing in placement of consultants and freelancers, claims that independent contractors are currently the fastest growing segment of the American workforce.

Cutting costs can be risky

Independent contractors are invaluable to many businesses, in terms of flexibility as well as talent.  They can be engaged and disengaged without the red tape and labor burden associated with hiring full-time employees.  Simply put, it costs less to pay independent contractors.  Employers who improperly classifiy workers as independent contractors, however, risk liability for back taxes and significant fines, even when the misclassification is unintentional.

IRS requirements for classification of employees and independent contractors are strict, but because employers stand to save so much money by classifying workers as independent contractors, they routinely disregard the rules. When employers pay independent contractors and report the compensation on IRS form 1099, they do not pay the payroll taxes and unemployment insurance required when employee compensation is reported on W-2 forms.

IRS audits may have a domino effect

According to and Gene Zaino, president and CEO of MBO Partners, most states now share data with the IRS and a noncompliance finding by the IRS is likely to lead to issues with state labor departments and other state agencies as well.  Given the new IRS compliance agenda and the interconnectedness of federal and state tax agencies, businesses hoping to avoid paying into unemployment insurance funds should take steps to verify independent-contractor classifications.

Businesses and workers should verify classification status

Businesses that utilize independent contractors should review applicable state and IRS classification guidelines or consult a tax attorney.  Workers or employers who are uncertain about classification can request a status determination by completing and filing IRS Form SS-8.

Good news for some

As the IRS heightens enforcement of classification rules, the cavalier hiring and firing of independent contractors may become a thing of the past. This is good news for workers who’ve gone years without social security or unemployment entitlements, and who’ve had to pay self-employment taxes as a result of misclassification. Classification as an employee also makes it easier to qualify for auto financing, home mortgages, payday loans and other forms of consumer credit.

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