Will the IRS audit your independent contractors?
Heather DeBlanc says there’s been a lot of buzz lately at conferences among attorneys and insurance consultants about the Affordable Care Act.
Specifically, DeBlanc, an attorney at Liebert Cassidy Whitmore in Los Angeles, says there have been rumors the IRS is increasing the audits it performs at higher education institutions to ensure schools aren’t misclassifying employees as independent contractors to avoid giving them health care insurance.
“Historically, not just with higher education but employers in general, there’s been a little bit of abuse or leeway when it comes to classifying individuals as independent contractors,” she says. “I think this is an excuse for the IRS to really start cracking down on it.”
Some of DeBlanc’s clients— including public agencies, community college districts and four-year institutions—have faced IRS audits focused on independent-contractor classifications, she says.
Rumor or not, colleges and universities must be accurate with their determinations and document their decisions. The process must prevent potential mistakes and catch intentional misclassifications that could trigger Affordable Care Act penalties that hold institutions liable for employment taxes.
Oftentimes, the human resources office fails to review the employee’s job description, DeBlanc says. “Employers assume, ‘I have a contract with these individuals and it says they are independent contractors so we’ll issue a form 1099 and they will be independent contractors,’ ” she says. “They should really look at the factual details of what the employees will be doing, what services they’re providing, how they’re devoting their time. That test includes both behavioral and financial aspects of the relationship.”
A good example is offered by Michael Cardman, legal editor at XpertHR. Take, for instance, a lecturer who instructs only a few classes, works one semester, is a specialist in her field and receives performance-based financial incentives. On paper, she would seem to be an independent contractor, but if the university controls and directs her performance through a detailed syllabus and lecture plans, that status could be jeopardized, Cardman says.
So how does one determine an employee’s classification? Some HR professionals ask the legal or accounting departments to make the call. Others reference the IRS’ 20-factor test (published online by Miami Dade College).
If there is still a question, you could let the IRS decide by completing Form SS-8, “Determination of Worker Status for Purpose of Federal Employment Taxes and Income Tax Withholding.” But do you really want to wait six months for a response?
When in doubt, the simplest approach is to classify individuals as employees, says DeBlanc. On the other hand, it may be cheaper for many schools to pay the penalty, which can be $260 per month for every month the misclassified individual is considered a full-timer.
Create a process, take control
Several years ago, when Cindy Matern joined the University of Puget Sound in Washington as associate vice president for HR/Career & Employment Services, she received a number of phone calls from accounts payable regarding invoices that managers submitted from independent contractors. Should invoices be processed through payroll or accounts payable?
“Too often the service has already been provided, a request for payment has been sent to accounts payable and it is then determined that the service constituted employment,” she says. “Fixing the issue at this point is very problematic.”
In response, HR developed strict policies and carefully explained them to all 750 staff and faculty at individual department meetings.
The rules are straightforward. Before hiring an independent contractor, every department must complete a nine-question checklist based on the IRS’ 20-factor test and submit it to HR for a determination. One question, for example, asks if the person is a student or university employee. If an employee, Matern says the individual is typically classified as such and paid through payroll.
However, there are many gray areas. Take a university music professor who is performing at a campus event. Is she hired as an independent contractor or employee?
Since she’s already on the school’s payroll, she is classified as an employee. But then consider an admissions clerk who runs a catering company on the side that has a business license and provides catering services for other organizations. If he caters a university event, is he an independent contractor or employee? In this case, he would be paid as an independent contractor.
“You keep thinking how many more scenarios can there be, but there is always a new one,” says Matern. “There are endless possibilities that come up.”
When the new policies were introduced, some believed they were inconvenient and requested a process that would provide immediate approvals. But complaints dwindled once Matern explained the ramifications of incorrect decisions, she says.
Using checklists definitely helps, says Jim L. Hargett, assistant vice president and controller at Oakland University in Michigan. The school, which supports 2,500 employees, requires each department to complete a tailored checklist based on the IRS’ 20-factor test before hiring an independent contractor. Then the university’s tax accountants, rather than HR, review the assessments to ensure classifications meet the IRS’ standards for independent contractors.
HR refers people to accounting whenever determination questions pop up. But some schools go wrong by making exceptions without valid reasons, Hargett says. “Someone wants this person to be an independent contractor—a department chair may try to wield more authority than he should and override the controls that are in place,” he says.
Even if HR doesn’t make determinations, the department can still help by addressing the topic at training sessions or employee orientations, Hargett says.
Meanwhile, it’s a bigger challenge to reverse the effects of an incorrect determination. Expecting people who performed past services to complete tax forms may be nearly impossible.
“My best recommendation is not to let the tail wag the dog,” says Matern of Puget Sound. The process must be driven by the HR or accounting departments, and not left in the hands of independent contractors, staff or faculty. “It’s so hard after the fact to do this right.”
Carol Patton is a Las Vegas-based writer who specializes in human resources issues.