Tax Compliance & Risks for 1099 Independent Contractors

Current Implementation of Tax Law

Employers act as agents for federal and state tax authorities to collect monies owed on W-2 income. For self-employed individuals no such third-party withholding exists so it is harder for tax authorities to ensure that the proper taxes are paid. This has resulted in a highly publicized campaign targeting independent contractors in the technology industry.

Legislation was enacted in hopes of increasing revenue by convincing the majority of independent contractors to convert to being employees so that payroll taxes would be collected by employers. The General Accounting Office calculates the governmental loss to be approximately $20 million annually due to wrongly classified independent contractors. Large budget deficits have been a motivating factor to dedicate funds to loss-recovery efforts. The campaign to reclassify independent contractors as W-2 employees has already generated at least $500 million dollars in penalties and back taxes theoretically owed by corporate America. IRS reports indicate finding wrongly classified independent contractors in more than 90% of the firms they audit.

The IRS has established a guideline of twenty questions for employers to determine whether their temporary employee is qualified to be classified as a 1099 Independent Contractor or would be more appropriately classified as a W-2 Temporary Contract Employee. The difference in classification has repercussions for both employer and contractor; the employer, however, runs the greatest risk from fines and back taxes should a misclassification be determined in an IRS or state audit.

When a professional contractor submits documentation to support a tax return Red Flags may be detected during processing of data. The IRS may quickly arrive on the employer’s doorstep to implement a non-compliance audit. Inconsistencies frequently trigger full-scale audits.

Although an audit may not occur during the contract period, the facts and circumstances of that contract exist and may arise in an IRS or state audit years later. The IRS will actively search for any inappropriate classification during such an audit.

Even though the contractor may have been responsible for a self-classification that later incurred an unfavorable judgement in a compliance audit, it is not the contractor that is at risk. If a 1099 contractor is reclassified from an independent contractor to an employee due to an IRS or state employment tax audit it is usually because the hiring company has been audited and that hiring company is then assessed with the withholding taxes, penalties etc.