Clients frequently ask, "What are my chances of being audited?” The answer varies by taxpayer type (business or individual), income level, and positions taken on returns, among many other factors. One thing clients can be sure of, however, is that the overall likelihood of an IRS audit is down more than 35% from five years ago, due to decreased IRS funding, a reduction in IRS personnel, and the IRS being forced to do more (e.g., combat identity theft refund fraud) with less. Whether this overall trend continues under the new administration, remains to be seen. Regardless, there may be cause for concern as to certain issues.
Treasury Secretary Steven Mnuchin has expressed a desire to increase IRS staffing and, if that happens, additional personnel might be allocated to IRS audits — though to what extent is not known. Keeping in mind, however, that the Treasury Inspector General for Tax Administration recently determined that nearly 70% of tax collections come from employment taxes (largely consisting of Social Security and Medicare taxes and income taxes withheld from employees’ wages), the IRS will likely continue to devote significant, if not additional, resources to auditing employment tax issues.
One such issue that raises concern is worker classification – that is, determining whether a worker is an employee or an independent contractor. In Friedman LLP’s recent survey* of business leaders, 75% of participants stated they use independent contractors, with further responses suggesting potential misclassifications and a risk of additional taxes and penalties — especially should there be a rise in employment tax audits. Ironically, when asked if they would like to see a decrease or increase in tax audits, 68% of these survey respondents were not in favor of a decrease (45% would like an increase, 23% find current levels appropriate).
How does the IRS determine whether a worker is an employee or independent contractor?
When making a determination of worker classification, the IRS generally considers evidence bearing on the business’s degree of control and the worker’s degree of independence. Facts that provide such evidence fall into three categories:
- Behavioral: Does the business owner control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? These include how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies, among other aspects.
- Type of relationship: Are there written contracts or employee type benefits such as pension plan, insurance, or vacation pay? Will the relationship continue and is the work performed a key aspect of the business?
In the IRS’s view:
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
Of the survey respondents who indicated they use (what they believe are) independent contractors:
- 46% of these workers do not have their own office;
- 46% do not have their own website; and
- 42% work for no one else.
While these facts may not be determinative, they arguably suggest that an element of independence may be lacking and that businesses should therefore undertake further examination to minimize their risk of penalties and taxes on audit.
What if a business determines that it was incorrectly treating its workers as independent contractors?
The business should consider the IRS’s Voluntary Classification Settlement Program (VCSP). A business in VCSP agrees to treat such workers as employees for future tax periods and only has to pay 10% of the employment tax liability (and for the most recent tax year only) that would have been due had the misclassification been discovered in an employment tax audit. There is no interest or penalties, nor will the business be subject to an employment tax audit for prior years as to the reclassified workers.
Because there’s always a distinct possibility that the IRS might discontinue a particular voluntary disclosure program, businesses should take advantage of VCSP while it’s still in place. Indeed, if remedial action is voluntarily undertaken, the consequences will be significantly less onerous than if the IRS discovers that such action could have been taken and wasn’t. And voluntary action, at least through a successful VCSP submission, will also eliminate any chance of audit regarding reclassified workers. That much, unlike what may happen with tax reform, is currently certain.
Check out our other tax reform insights in this series:
- Business leaders favor sweeping tax reform proposals, with some hesitancy towards international proposals
- A majority of businesses would offer the same or more health benefits if ACA repealed
- Survey Says: Mixed Reaction to International Tax Reforms, Impact Remains Uncertain
- Survey Finds Businesses with Online Sales May Not Be Prepared for States’ Broader Interpretations of Nexus Rules
- Businesses Would Likely Alter Their Entity Structure and Finance Models Based Upon Tax Changes.
*Friedman LLP conducted the web-based survey in early 2017 among companies across the United States, with a focus on the New York, New Jersey, Pennsylvania, and Connecticut areas. The survey compiles responses from 483 senior leaders of companies across industries including technology/computer services, manufacturing/distribution/wholesale, healthcare, retail, real estate, financial services, architecture/engineering, marketing and advertising, nonprofits, law, and more. The size of the companies surveyed ranged from below $10 million in annual revenue to over $500 million. The respondents include business owners, company presidents, chief executive officers, partners, directors, chief financial officers, controllers, and managing directors. All insights in this series are based upon the specific responses of the business leaders who participated in our survey.