Academic journal article Journal of Accountancy

Independent Contractor or Not? Companies Should Beware of Service-Provider-Initiated Classification Changes

Academic journal article Journal of Accountancy

Independent Contractor or Not? Companies Should Beware of Service-Provider-Initiated Classification Changes

Article excerpt

The IRS is responsible for determining whether an individual who provides services to a business is an independent contractor or an employee. Although many independent contractor relationships begin at the request of the service provider, this is no guarantee the IRS will not challenge the classification. In some instances the service provider may later claim employee status, triggering an IRS audit. This article suggests some preventive measures CPAs can recommended employers or clients take to avoid a successful IRS challenge when an independent contractor seeks to be reclassified as an employee.


Some service providers prefer independent contractor status because of the tax benefits not available to employees, including being able to contribute significant dollars to their own qualified retirement plan and deducting legitimate business expenses. Whatever the provider's reason for wanting to be classified as an independent contractor, the business remains the entity the IRS and the courts will go after for any misclassification. Some of the obvious tax and financial benefits to the contracting business of avoiding classifying a service provider as an employee include

* No need to provide medical insurance.

* No payments of retirement benefits.

* No employee payroll taxes.

* Obtaining services at a fixed rate, no matter what the time required to complete the assignment.

* Employee recordkeeping, clerical and other administrative cost savings.

In light of these benefits, it is very easy for a contracting party to give in to the wishes of a potential service provider who wants to be classified as an independent contractor.

However, if the worker is successful in having the IRS reclassify him or her as an employee at some later date, the contracting party faces certain risks: * Liability for back payroll taxes, plus penalties and interest.

* Court time and costs for any related litigation.

* Out-of-court settlements to make the issue go away.

* Unwelcome attention and embarrassment.

* Criminal sanctions, including imprisonment and fines.

* Personal liability for corporate officers of up to 100% of the amount the employer should have withheld from the employee's compensation in payroll taxes.

* Invalidation of benefit plans.


A service provider the IRS deems to be an employee can make a variety of claims against the employer. These include

* Overtime pay under the Fair Labor Standards Act if the hours he or she provided to the contracting party in the past exceeded the standard workweek.

* Retirement benefits.

* Medical coverage for injuries sustained on the contracting party's property.

* A shift in liability from the service provider to the contracting party for injuries to other people or damage to property.

* A shift in responsibility for harassment charges from the service provider to the contracting party.

* Unemployment claims.

Service providers also could sue for the right to have stock options, participate in profit-sharing plans and receive disability payments, workers' compensation and more. Businesses generally will not face this problem if they have a quality, ongoing working relationship with their independent contractors. Assuming both parties are following independent contractor classification guidelines, difficulties

usually occur only when the relationship sours and the service provider feels unduly harmed.

When it is the service provider who seeks reclassification, the IRS may flag the contracting party for an audit of how it classifies all of its independent contractors. If the audit results in the reclassification of more than one independent contractor as an employee, the financial consequences could be ruinous. …

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