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If you are going through or will be going through an IRS Employment Tax or Payroll Tax Audit, the IRS will use what is called a common law test to make determinations. Beware! Do not go into the IRS without representation. The effects of this tax audit have personal implications as well. If the IRS makes an adjustment to audit, they will not only look to collect the money from your business, but they can also collect money from you individually as well.
Employee or Employer Test for payroll or employment tax audits
The Internal Revenue Service Factors for Evaluation for Employee or Employer Test
There are two general tests the IRS uses for the determination for the Employment Tax Audits or Payroll Tax Audits
- Common Law Test
- Reasonable Basis Test
Common law test for payroll tax audits or employment tax audits
What was the:
- Level of instruction. If the company directs when, where, and how work is done, this control indicates a possible employment relationship. The IRS will look for training manuals and policies the companies use. The IRS can use former employees to answer these questions as well.
- Amount of training. Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished. The more training, the Service takes the position that the individual is an employer.
- Degree of business integration. Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees. Those whose services are for the production of income to a great level are scrutinized more closely.
- Extent of personal services. Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone. Once again this goes to control.
- Control of assistants. If a company hires, supervises, and pays a worker’s assistant, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship. There are exceptions to this.
- Continuity of relationship. A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects. Also, does the individual have another job or is this the sole source of their income. Is their license available to everyone?
- Flexibility of schedule. People whose hours or days of work are dictated by a company are apt to qualify as its employees. Does the individual punch a time clock or is the employee free to come and go? Does the person have a key to the facility?
- Demands for full-time work. Full-time work gives a company control over most of a person’s time, which supports a finding of an employment relationship. The IRS will look to see if the individual has other W-2 income.
- Need for on-site services. Requiring someone to work on company premises—particularly if the work can be performed elsewhere—indicates a possible employment relationship. Are name badges and uniforms required?
- Sequence of work. If the company requires work to be performed in specific order or sequence, this control suggests an employment relationship. Does the employee do the same thing every day?
- Requirements for reports. If a worker regularly provides written or oral reports on their the status of a project, this arrangement indicates a possible employment relationship. Is there an evaluation given?
- Method of payment. Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships. Time clocks tend to look like hourly employees. What does the tax return of the individual look like?
- Payment of business or travel expenses. Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship. Does the individual have a company credit card or expense account, how about a possible credit card of the company?
- Provision of tools and materials. Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding. The checking of the individual 1040 for a schedule C expense form is a good cross check for the IRS.
- Investment in facilities. Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employer to provide work facilities. Are there incentive programs for the individuals?
- Realization of profit or loss. Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees. Is the individual on a pension system or health insurance?
- Work for multiple companies. People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors. That is why the individual tax returns may be checked.
- Availability to public. If a worker regularly makes services available to the general public, this supports an independent contractor determination. Does the individual have other business cards and is their business open to the public? Does the person have other work going on at the same time?
- Control over discharge or firing. A company’s right to discharge a worker suggests an employment relationship. In contrast, a company’s ability to terminate or fire the independent contractor relationships generally depends on contract terms. Is there a contract between both parties. does it contain accurate details? You will find below a sample of a contract.
- Right of termination. Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.
Reasonable Basis Test for payroll or employment tax audits:
While the common law test looks at the nature of the working relationship, the reasonable basis test is based on how the courts and the IRS have classified similar workers in your company or your industry in the past.
The reasonable basis test is considered a “safe harbor.” If you can show you had a reasonable basis for treating a worker as an independent contractor, the IRS is prohibited from reclassifying the worker as your employee either prospectively or retroactively. You have a reasonable basis for treating a worker as an independent if one or more of the following conditions exist:
- A court ruling in favor of treating workers in similar circumstances as non-employees; A ruling by the IRS (usually a Revenue Ruling) stating that similar workers are not employees subject to employment taxes;
- An IRS Technical Advice Memorandum or Private Letter Ruling issued to your company, indicating that the particular worker isn’t an employee;
- A past IRS payroll audit that didn’t find workers in similar positions at your company to be employees; or
- A longstanding, widely recognized practice in your industry of treating similar workers as independent contractors.
- Because of the marketing specialization program, the IRS has a real good idea of each industry. You will not fool the IRS.
Which are the most important of the factors:
The IRS test often is termed the “right-to-control test” because each factor is designed to evaluate who controls how each job or how the work is performed. Under IRS rules and common-law doctrine, independent contractors control the manner and means by which contracted services, products, or results are achieved. The more control a company exercises over how, when, where, and by whom work is performed, the more likely the workers are employees, not independent contractors.The principle is very simple, control determines everything.
A worker or individuals do not have to meet all the criteria to qualify as an employee or independent contractor, and there is no single factor is decisive in determining a worker’s status. The individual circumstances of each case determine the weight IRS assigns different factors. All the factors contribute to the IRS conclusion.
What are the important factors “High Priority Factors” on payroll or employment tax audits:
- W-2 or 1099: You report payments to independents (if they total $600 or more in a calendar year) on Form 1099-MISC. Reporting on a Form W-2 indicates that both your company and the worker consider the worker to be your employee.
- Intent of your company and of the worker: To build a solid case, you and the worker should sign a written agreement stating the worker is an independent contractor who will be paid by the job or project, provide his or her own tools, etc.
- Pay basis: If you pay a worker on an hourly, weekly, or monthly basis, the IRS will consider it a sign the worker is your employee. An independent is generally paid by the job, project, assignment, etc., or receives a commission or similar fee.
- Benefits: Providing benefits other than pay are a strong indicator of employee status. Incorporated status: Workers who are incorporated are generally considered to be working for themselves, not as your employee.
- Importance of the worker’s services: If a worker provides services that are integral to the success of your business, the worker is likely your employee.
- Personal performance of services: An independent contractor should have the freedom to hire assistants or subcontract work to other workers or firms at his or her expense (this is where profit or loss could enter the picture). If you require the worker to perform the work personally, that’s a sign of control and therefore indicative of employee status.
- Providing assistants: There’s likely an employer-employee relationship if your company hires, supervises, and pays assistants for the worker.
- Ongoing relationship: The worker doesn’t have to work for you continuously to be considered an employee; it may be enough if the worker gets assignments at frequently recurring, even if irregular, intervals.
- Setting the order or the sequence of the work: If you determine what gets done when, it indicates you control how the work is performed. Allow an independent to decide his or her schedule, both day-to-day and for the longer term.
Other Factors the courts and IRS looks at in regard to payroll tax audits or employer tax audits
Behavioral Control – Facts that show whether the business has a right to direct and control.
- When, where, time in a project and how to work
- What tools or equipment to use, personal or shop tools
- What workers to hire or to assist with the work, your subs or their employees
- Where to purchase supplies and services, their vendors or yours
- What work must be performed by a specified individual or individuals
- What order or sequence to follow, was there a plan given to the individual
Type of Relationship:
Facts that show the type of relationship include:
- Written contracts describing the relationship the parties intended to create or not create
- Whether the worker or individual is provided with employee-type benefits i.e. pension, insurance
- The permanency of the relationship , how long has the relationship existed
- How to integrate the services are to the principal activity of the business.
Who had financial control – Facts that show whether the business has a right to control
Business aspects of the worker’s job include:
- The extent to which the worker has reimbursed expenses
- The extent of the worker’s investment
- The extent to which the worker makes services available to the relevant market
- How the business pays the worker
- The extent to which the worker can realize a profit or loss