Worker Classification Woes

Typically when the Internal Revenue Service (IRS) indicates an interest in an area it’s best to take preliminary steps to ensure your institution is compliant. In response to the IRS’s plans to audit the worker classification practices of 6,000 randomly selected organizations, NACUBO hosted the webcast, “Fringe Benefits, Worker Classification, and Accountable Plan Compliance: Aligning Relevant Campus Functions,” featuring Marianna Dyson and Michael Lloyd of Miller & Chevalier and Linda Schutjer of Colorado State University.

While many of the institutions the IRS may look at will be large universities, smaller institutions should also take heed and begin preparing an action plan. What the IRS hopes to learn is how businesses go about classifying workers as independent contractors. In particular, the three-year national research project will illuminate how worker classification will impact the U.S. tax gap—the difference between what the government collects and how much it estimates should be collected—and to measure the level of compliance with respect to worker classification.

As Dyson views it, higher education is lucky. A warning has been issued and institutions should use this warning as an opportunity, she asserted. Dyson encourages changes in plans, procedures, and policies to ensure compliance, and notes that “self-correction is often the best story to tell.”

In addition to concerns for an institution’s tax office (fringe benefits, cell phone, accountable plan compliance, etc.); the human resources office will need to join in this team effort with information about employee classification. Audits will focus on whether an institution’s independent contractors should be treated as employees. If an institution misclassifies an employee as an independent worker, it’s on the hook for unpaid income taxes, federal unemployment taxes, and FICA withholdings. The government will then use that data to compute the employment tax gap and to focus its audit efforts on the most noncompliant employment tax areas.

The last time the IRS conducted a similar audit was 25 years ago when the agency concluded the share of the tax gap that could be attributed to misclassification was roughly $1.6 billion. “There is a sense that (the misclassification tax gap) is a lot bigger now because of time and because of the way that technology has changed the worker relationship,” says Lloyd. “There are a lot of new ways of doing things, ways to be at home and work.”

Likewise, independent workers constitute a growing part of the higher education workforce. The audits are expected to be thorough and time-consuming and may run concurrently with an income-tax audit or could result in an income-tax audit if the IRS uncovers something worth a closer look.

Worker Classification Tax Audits

Dyson, Lloyd, and Schutjer offered some best practices for classifying independent contractors and what to do if your institution ends up as the target of a worker classification tax audit.

What to do now:

• Explain to your board and leadership the potential impact of an audit. Because employers are liable for any payroll taxes they have failed to pay or withhold, this reason alone should cause concern, explains Dyson. The ultimate cost in dollars and labor to remedy any errors could be high.
• Develop your team. Establishing counsel as your lead and identifying your tax, accounts payable, payroll, and human resources team members is critical for taking action in a timely manner.
• Review your contracts. Unless you’re dealing with someone who is a well-recognized independent contractor (e.g., lawyer, accountant, building contractor), you’ll want to execute a written contract with each independent vendor that spells out that he or she is a contractor, advises Lloyd. Additionally, you’ll want to require him or her to file all appropriate tax returns as an independent contractor.
• Employ experienced contractors. Another way to protect your institution is to avoid providing the worker with training. Hire people who already know what they’re doing. You should also have the contractor bill you on a regular basis to create a paper trail.
• Document why you are treating someone as a contractor. The safe harbor provisions of section 530 of the Internal Revenue Act of 1978 provide the best defense against an audit. According to these provisions, a taxpayer must satisfy three criteria to be eligible for safe harbor treatment:
  
  
  1. There was a reasonable basis for treating a worker as an independent contractor. (Reasonable basis can be shown through judicial precedent; past IRS audit treatment; longstanding industry practice; and other reasons, including reliance on the advice of a qualified tax professional.)
  2. Workers with substantially similar positions must be treated consistently.
  3. A taxpayer must have filed all required federal tax returns consistently with its treatment of the workers. In most cases, if you can show that the 530 safe harbor treatment applies, you’re done as far as an audit is concerned. Documenting the information that leads you to conclude that a person is an independent contractor is a smart move.

What to do during an audit:

• Be timely. If you do get audited, hopefully you have taken some of the aforementioned steps. If not, put on your bravest face and push forward. “A best practice is to try to get off on a good foot with the agent when there is an examination,” says Schutjer. “Be timely and do not be adversarial.”
• Have worker contacts ready. In the event of an audit, an IRS agent is going to want to talk to your workers to see if they confirm what you say.
• Be ready for what they already know. Has your institution been sued by employees over benefits in the past? If so, be prepared to answer questions about the litigation.
• Remain calm. “Understand that mistakes will be made,” notes Schutjer. “This is going to take awhile and will be a distraction, and losing your cool because of an error won't help.” Because these audits are part of a research project, the agent is going to pursue the audit until all required data is collected, even if it looks like you’ve correctly classified your workers. And, since the audit is likely to last about six months, you’ll probably want an intermediary such as a tax adviser or lawyer to handle the process.

Resources

• NACUBO Webcast On-Demand Program
• IRS 20-Factor Test: Independent Contractor or Employee

Tadu Yimam is a policy analyst at NACUBO. E-mail: tadu.yimam@nacubo.org.