IRS Will Audit 6,000 Businesses and Some May Owe Lots of Money

Employers are uncertain about the economy and are waiting for clearer signs of recovery before hiring new employees.

Meanwhile, productivity, sales and even profits continue to nudge forward. As a result, businesses are hiring temporary workers and outsourcing tasks to independent contractors.

Independent contractors are paid to complete specific assignments. At the end of their assignments, the contractors are given the Internal Revenue Service form 1099 depicting the amount paid for the task. By contrast, employees are paid wages and get IRS W-2 forms.

There are no payroll taxes deducted from independent contractors. Furthermore, unemployment tax and workman's compensation insurance premiums are not deducted because it is not the employer's responsibility to pay them. So if the contractor gets hurt on the job, it will not cause the employer's workman's compensation premiums to increase. Likewise, if the contractor is "fired," the employer will not get its unemployment tax raised.

Independent contractors do not receive health insurance, 401(k)s, paid vacations or other benefits being given to salaried workers.

Even the new health-care bill gives some small-business owners an incentive to hire independent contractors instead of salaried employees. That is because starting in 2014, the new law requires employers with more than 50 employees to either provide health insurance for their salaried workers or pay a penalty of $750 per year for each of them.

But before you decide to convert all of your employees to independent contractors, you need to know the difference as defined by federal and state law. What is more, the IRS is gunning for businesses that mischaracterize employees to avoid payroll taxes.

Last year, IRS announced a three-year program to audit 6,000 businesses at random. They are hoping to find employee misclassifications in order to collect back taxes owed along with interest and penalties. They plan to add $7 billion to the agency's collections over the next 10 years.

Consequently, it is time for you to bone up on what is required for IRS to classify your worker as an independent contractor.

A written "Independent Contractor's Agreement" is not enough. IRS is more concerned with how much control you exert in the relationship than what is in the written agreement. They look at three categories: behavioral control, financial control and the type of relationship of the parties.

You can download an IRS pamphlet explaining how to classify your workers.

Just when you have mastered IRS's requirements, the Department of Labor comes knocking with its own set of requirements. It is concerned with violations of the Fair Labor Standards Act, such as the minimum wage requirements.

For more information the Department of Labor's fact sheet.

Most states have additional regulations. In Florida, for example, the state categorically eliminated the classification of "independent contractor" in the construction trades, for the purpose of worker's compensation compliance. Instead, Florida requires sole proprietors in the construction trades to form LLCs or corporations.

Otherwise, an unincorporated, sole-proprietor tradesperson may be classified as your employee under Florida law. In that case you may have to provide workman's compensation insurance for her and will otherwise be liable for injuries occurring while she is in your employ.

To be safe in Florida, ask for proof of her business entity before hiring a construction tradesperson.

Lastly, check with a labor lawyer and tax professional if you are in doubt about how to classify your workers.

Jerry Chautin is a volunteer SCORE business counselor, business columnist and SBA's 2006 national "Journalist of the Year" award winner. He is a former entrepreneur, commercial mortgage banker, commercial real estate dealmaker and business lender. You can follow him at www.Twitter.com/JerryChautin