Counter IRS Audits by Properly Classifying Workers (Part I)

The IRS is wary of the economic incentive that employers have to misclassify workers as independent contractors rather than employees to cut benefit costs and avoid compliance burdens.

October 6, 2008
Sponsored by Thomson Reuters

by James Parker, JD and Claire Nash, CPA

(From Practical Tax Strategies (September 2008), p. 132)

The IRS has announced an initiative to increase audits of small business tax returns. During these audits, the IRS will undoubtedly examine and challenge the appropriateness of an employer’s classification of workers as independent contractors. Part I of the article discusses early judicial decisions that establish control or the right to control, as the primary factor determinative of worker status and the safe harbor provisions of section 530 of the Revenue Act of 1978, which protect an employer’s consistent classification of workers as independent contractors. Part II (in next month’s issue of Practical Tax Strategies) examines Rev. Rul. 87-41, 1987-1 CB 296, which sets forth factors to consider when classifying workers and Form SS-8,which can be used by taxpayers to request a determination of worker status from the IRS.

The Latest IRS Initiative

As governmental entities at all levels in the U.S. look for more tax revenues, it is not surprising that Congress is focusing attention on the “tax gap,” which is the difference in the tax revenues that the federal government actually collects and the amount that it would collect if all taxpayers fully complied with the federal tax laws and paid their taxes on time.1 The latest figures released by the IRS, which are for 2001, estimate the U.S. federal tax gap at $345 billion.2 The tax gap drops to $290 billion after voluntary late payments and revenues generated from collection efforts are taken into consideration.3 It is estimated that underreporting of income generated $285 billion of the 2001 tax gap. The report attributes $39 billion of the gap to underpayment of self-employment taxes and $109 billion of the gap to underpayment of taxes on business income of individuals.4 Clearly, narrowing the tax gap presents Congress with an opportunity to increase revenues significantly without having to increase tax rates. One way to narrow the tax gap is through increased audit activity by the IRS. The IRS has historically managed to collect four dollars in delinquent taxes for every dollar spent on enforcement.5 This statistic concerning the direct result of enforcement efforts is impressive even without taking into consideration the indirect effects of increased enforcement efforts. Voluntary compliance increases when it becomes known that the likelihood of audit has increased. Accordingly, the IRS announced plans to increase its audit activity significantly and Congress allocated $410 million for fiscal year 2008 to fund new IRS enforcement initiatives.6 One of the practices that the IRS scrutinizes during audits of both small businesses and large firms is the classification of workers as independent contractors, rather than employees.

Motivation for Misclassification

The Federal Insurance Contributions Act (FICA), created the duty for employers to withhold FICA taxes from employee wages and pay a matching share. Initially, FICA imposed a mere one percent tax on maximum earnings of $3,000 per employee. The initial rate and maximum earnings amount remained unchanged until 1949.7 At the inception of the tax in 1937, few employees actually paid the maximum tax of $30 per year. This initial FICA amount of $30 per year was hardly a sufficient motivation for employers to misclassify employees as independent contractors. The FICA tax rate for both employers and employees has been increased by Congress over the years to its current level of 7.65 percent. Moreover, there is no maximum level of income to which the 1.45 percent Medicare rate is applied and the maximum level of income to which the Social Security rate is applied is adjusted annually to reflect the change in average earnings in the U.S. This annual adjustment has increased the maximum Social Security earnings to $102,000 per worker for 2008. Self-employed taxpayers pay a nominal rate of 15.3 percent in self-employment tax on their first $102,000 in self-employment income, which is the combined rate of the employer’s and employee’s shares of FICA tax. Certain adjustments reduce the effective rate to approximately 12 percent for most self-employed taxpayers. By misclassifying workers as independent contractors, employers avoid the compliance burden of calculating and withholding taxes from employees’ earnings, paying the withholdings to the U.S. Treasury and reporting those amounts on the appropriate forms. More importantly, employers avoid paying their matching shares of FICA taxes and unemployment taxes. By misclassifying workers as independent contractors, employers also avoid other employee benefit costs, such as workers’ compensation insurance on covered employees, retiree plan costs and health and welfare benefit costs. Workers who are classified as employees have little opportunity to underreport their earnings to the IRS. A worker who exercises some control over the work performed for an employer may wish to be treated as a self-employed independent contractor because independent contractors are taxed on their “net earnings from self-employment.” Workers who prefer to be treated as independent contractors see the classification as an opportunity to deduct business expenses from their reported earnings and, correspondingly, to minimize the combined federal income and self-employment taxes due on those earnings. Although misclassification of a worker as an independent contractor merely shifts the burden of compliance from the employer to the worker who would be required to pay self-employment tax in place of FICA tax, it gives the worker an opportunity to underreport his or her earnings. Therefore, it is not surprising that early court decisions resolving the issue of whether a worker was an employee or an independent contractor, involved disputes with the IRS in which individual taxpayers wanted to be classified as independent contractors in order to be eligible to take deductions as business expenses and reduce their taxable incomes.

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James O. Parker, JD/MLT, is a professor of business law at Christian Brothers University in Memphis, Tennessee. Claire Y. Nash, PhD/CPA, is an assistant professor of accounting at the Barry Kaye College of Business at Florida Atlantic University.


1 “Reducing the Federal Tax Gap, A Report on Improving Voluntary Compliance,” IR-2007-137, 8/2/07, p. 6.
2 Id., p. 8.
3 Id.
4 Id., p. 10.
5 Id., p. 2.
6 Id. , p. 2.
7 The 2005 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Fund, Social Security Administration, pp. 124-125.