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Are you next on the IRS misclassification audit list?

March 25, 2013

Article courtesy of SBAM Approved Partner ASE

By Anthony Kaylin

Wage and Hour cases have been pursued very aggressively by the federal government over the past few years.

NERA Economic Consulting’s “Trends in Wage and Hour Settlements” analyzes cases involving allegations of current and/or former employees’ unpaid work, including unpaid overtime, failure to provide meals and/or rest breaks, and off-the-clock work. Some of the study’s findings:

  • Wage and hour settlements for U.S. companies totaled $467 million in 2012.
  • For 2012, 102 wage and hour cases were settled, compared to 107 in 2011.
  • On average, companies paid $4.8 million to resolve a case last year, up slightly from the $4.6 million identified in 2011.
  • The median settlement value for wage and hour cases was $1.7 million in 2012, only slightly higher than the $1.6 million median observed in 2011.

Now comes the worker misclassification issue. According to The Wall Street Journal, anywhere from 10% to more than 60% of today’s workers may be misclassified as independent contractors. Is this a real issue for the government?

The answer is yes. Consider the results of a 2009 Michigan State University study of 894 random audits of Michigan employers covered by unemployment compensation insurance:

  • On average, 30% of Michigan employers misclassify employees as self-employed workers, or under-report employee payroll.
  • 20% of the employees of employers who misclassify are either erroneously classified as self-employed or receive payments that are not reported as part of payroll.
  • In all, 8% of all Michigan employees are misclassified as self-employed or receive undeclared income from their employer.
  • At the time, the study estimated it cost Michigan approximately $1.9 billion in unemployment taxes.

The IRS, in conjunction with U.S. Department of Wage and Hour, established a Voluntary Classification Settlement Program (VCSP) for employers to reclassify independent contractors as employees if they are misclassified.  The VCSP is optional and provides taxpayers with an opportunity to voluntarily reclassify their workers as employees for future tax periods with limited federal employment tax liability for the past non-employee treatment.

The IRS will be auditing over 6,000 employers to determine if their use of the contractor classification is correct or not. Employers need to beware. The government recognizes, especially with smaller employers, that the use of contractors is high. It also recognizes that with the arrival of the small/large employer tipping point of 50 or more employers under the Affordable Care Act, those smaller employers will have a very strong incentive to stay officially “small” to avoid having to provide health insurance. Aside from that consideration, any employer with a large number of “1099” workers (i.e., independent contractors) should also end up on the IRS’s target list.

Are these audits being done with the contractor/employee in mind?  It appears that employee relief is a secondary consideration. The primary on is increased tax revenues. Employers don’t pay or withhold income taxes, Social Security, Medicare or unemployment taxes for independent contractors. The U.S. Treasury estimates that forcing employers to properly classify their workers would yield $8.71 billion in additional tax revenue over the next decade.

Yet contractors are a major avenue of growth for many firms. SurePayroll is a Chicago-based payroll-management firm whose clients are generally small employers. SurePayroll estimates that the proportion of contractors on the 80,000 small-business payrolls it processes every month has nearly doubled over past six years, rising to 6.7% in February 2013 from 3.4% in February 2007. Other studies have also shown some business owners saying the IRS audits could stifle their ability to grow as demand picks up.   “I’m either going to hire someone full-time to do a job or we just won’t do it,” says Ciaran Dwyer, chief executive of 3t Systems Inc., a Denver-based IT company with 65 full-time workers.

This government whack is coming. To avoid it, employers, especially those who rely on contractors, should review the IRS guidelines and make sure they are walking the straight and narrow. Otherwise fines, payments of back taxes and bad publicity could result from an IRS audit of this type. Further, the State of Michigan could piggyback on the feds’ actions and require back payments of unemployment taxes.

If those employers have not done their classification project yet, they need to do it now. It will save time and expense in the future. The VCSP will give them an opportunity to proactively correct any mistakes they find.

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