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IRS reclassification

IRS reclassification

Overview
IRS reclassification as an employee occurs where persons claimed as (or claiming to be) independent contractors are recategorized by the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the United States federal government agency that collects taxes and enforces the internal revenue laws. It is an agency within the U.S. Department of the Treasury and is responsible for interpretation and application of Federal tax law. The official U.S...

 (IRS), or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back-taxes for which the employer is generally liable. These amounts could cost a business large sums of money.
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Encyclopedia
IRS reclassification as an employee occurs where persons claimed as (or claiming to be) independent contractors are recategorized by the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the United States federal government agency that collects taxes and enforces the internal revenue laws. It is an agency within the U.S. Department of the Treasury and is responsible for interpretation and application of Federal tax law. The official U.S...

 (IRS), or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back-taxes for which the employer is generally liable. These amounts could cost a business large sums of money. The U.S. Government Accountability Office
Government Accountability Office
The Government Accountability Office is the audit, evaluation, and investigative arm of the United States Congress. It is located in the legislative branch of the United States government....

 (GAO) (formerly known as the General Accounting Office) reports that the IRS claims to lose millions of dollars in uncollected taxes because of misclassification of independent contractors by taxpayers.http://www.gao.gov/archive/1996/gg96130t.pdf According to IRS Commissioner
Commissioner of Internal Revenue
The Commissioner of Internal Revenue is the head of the Internal Revenue Service , a bureau within the United States Department of the Treasury.The office of Commissioner was created by Congress. See the Revenue Act of 1862...

 Mark W. Everson
Mark W. Everson
Mark W. Everson served briefly as President and Chief Executive Officer of the American Red Cross. From May 1, 2003 to May 6, 2007, he served as a Commissioner of Internal Revenue. He resigned this position to join the American Red Cross, and quickly left that position following a scandal...

 in a statement made November 3, 2005, IRS audits of small businesses organized as corporations increased from 7,294 in 2004 to 17,867 in 2005. http://www.irs.gov/newsroom/article/0,,id=150358,00.html

Who is being classified?


Employers must report the incomes of employees and independent contractors using the IRS form W-2 and 1099, respectively. Employers pay different tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law.Taxes are also imposed by many subnational entities...

es (i.e. Social Security
Social Security (United States)
Social Security in the United States currently refers to the federal Old-Age, Survivors, and Disability Insurance program....

 and Medicare
Medicare (United States)
Medicare is a social insurance program administered by the United States government, providing health insurance coverage to people who are aged 65 and over, or who meet other special criteria. The medicare program also funds residency training programs for the vast majority of physicians in the...

 taxes, unemployment tax
Federal Unemployment Tax Act
The Federal Unemployment Tax Act is a United States federal law that imposes a federal employer tax used to fund state workforce agencies. Employers report this tax by filing an annual Form 940 with the Internal Revenue Service...

es, etc.) on the wages of a worker that is classified as an employee. However, these same taxes are generally not paid by the employer on the compensation of a worker classified as an independent contractor. If an employer mistakenly classifies an employee as an independent contractor, the employer is then at risk for being heavily fined and paying back-taxes.

Employee vs. independent contractor


According to the IRS, an employee is anyone who performs services for an employer if the employer can control what will be done and how it will be done. This was codified in revenue ruling 87-41, and is generally called "the twenty factor test". http://www.ncarts.edu/formsprocedures/IRS.htmhttp://www.irs.gov/pub/irs-pdf/p15a.pdfhttp://www.irs.gov/businesses/small/article/0,,id=99921,00.html Independent contractors are defined so if the payer or employer has the right to control or direct only the result of the work done, and not the means and methods of accomplishing the result. There are also other categories such as non-employees, which include direct sellers.http://www.irs.gov/charities/article/0,,id=128602,00.html

Mitigating IRS reclassification risk


One must determine if an evaluation of a worker’s classification is necessary. Independent contractors on an approved vendor
Vendor (supply chain)
A vendor, or a supplier, is a supply chain management term meaning anyone who provides goods or services to a company. A vendor often manufactures inventoriable items, and sells those items to a customer.-History:...

 list, or whose services are on an exempt services list, may not require an evaluation. Also, independent contractors immediately willing to become W-2 employees through a Portable Employer of Record will not require an evaluation.
If the analysis is necessary, a qualified Compliance Officer attempts to produce an accurate judgment of the workers classification, and delivers his or her written recommendation to the employer.

A Compliance File, including all necessary supporting documentation for the compliant independent contractor, is kept on file in the event of an audit
Audit
The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. Audits are performed to ascertain the validity and reliability of information; also to provide an assessment of a system's internal control...

.

External links and resources