The “gig economy” works in large part by employing independent contractors instead of employees in order to keep costs down. That has led to some headaches — whether or not a worker is an employee or a contractor is a legal determination under the Fair Labor Standards Act. It’s not strictly the choice of the employer.
In order to ensure you’re using independent contractors rather than hiring employees, you’ll need to comply with the federal legal standards for an independent contractor relationship. In general, that means that your contractor cannot be hired to do the same work in the same way that an employee would. The test is essentially how much control over the work the employer exercises, along with how integral the work is to the employer’s business.
When you classify a worker as an independent contractor, there are a number of consequences. Contractors aren’t eligible for overtime pay or employee benefits. They must provide their own workers’ comp insurance. Most important from a tax point of view, they pay their own employment taxes. For employees, of course, the employer pays half of those taxes and withholds the employee’s half from their paychecks.
With federal taxes involved, the answer is yes, you can be audited for working with independent contractors, especially if you’ve misclassified them. IRS red flags include treating them like employees, giving them specific hours to work or are having them perform work too similar to that of employees.
Another way an audit can be triggered is if the contractor files for unemployment benefits. Or, the worker may file an IRS SS-8 form requesting a determination of whether they are lawful contractors or should be classified as employees.
Audits are happening. The gig economy has meant many instances of misclassification, and the IRS says, for example, that the number of taxpayers being penalized for underpaying their estimated taxes jumped by 40 percent between 2010 and 2015.
An IRS audit may be resolved after the first letter — or it may require a great deal of time, effort, and legal expenses. Your best bet is to hire experienced tax counsel and to back up your classification decisions with corresponding policies and paperwork.
If you believe you have misclassified employees as contractors, the IRS may allow you to avoid an audit and penalties by proactively reclassifying your workers as employees. This can be done through the Voluntary Classification Settlement Program, or VCSP. Before taking advantage of this program, however, it’s important to understand all your options and the potential consequences. Talk to a tax lawyer before you engage with the IRS.