The Internal Revenue Service announced in late September a new initiative aimed at workers improperly claimed as independent contractors. This voluntary program is for those who are not under a current IRS, Department of Labor or State agency exam. The company must have issued 1099-M's and been consistent in treating these workers in the past.

If you misclassify workers the penalties can be rather onerous. If you issue 1099-M's then you may be required to pay the employer's share of Social Security and Medicare, 20% of the employee's Social Security and 1.5% of the "wages" as withholding. If no 1099's were issued then you are faced with doubling the employee portion and a 3% calculation on the "wage" withholding. If you intentionally disregard the rules then all bets are off and you may be required to pay both sides of the Social Security and Medicare taxes and 25% in "wage: withholding before the imposition of penalties and interest.

This voluntary program will assess the amount due at 10% of the amount due under the rules for those issuing 1099's for amounts paid in 2011. The employer will have to agree to treat these workers as employees in the future and agree to extend the statute of limitation related to these employees by three years.

This is a fairly generous program particularly as the IRS versus the taxpayer friendliness pendulum is firmly against the taxpayer these days. Employers that issue 1099's already have powerful protections from assessments. Section 530 of the 1978 Revenue Act applies employers who have consistently treated all similarly situated workers as independent contractors, filed all applicable federal returns consistent with that treatment and have a reasonable basis for treating the worker as an independent contractor. Reasonable basis is defined as a previous judicial precedent, a previous IRS audit where these workers existed but no assessment was made (even if the issue was not examined) or if it is a long standing practice in the industry. If the employer establishes any reasonable basis then the burden of proof switches to the IRS to prove otherwise.

So now you're thinking that issue 1099's and I have some reasonable basis for classifying these workers as independent contractors so I'm protected. The problem comes from state agencies. Most independent contractor disputes come from former independent contractors showing up at the unemployment office or looking for disability or workers compensation benefits. The state agencies are not under the Section 530 protection and will convert these workers to employees and can hit you with rather substantial assessments.

So how do you make the decision between employee and independent contractor? The IRS has Form SS-8 that will go through a series of questions related to what the worker does and what types of control the employer has over the worker, both behavioral and financial controls. In the broadest terms if the worker has an independently established business, takes a financial risk and you have limited ability to direct and control the worker then he or she is likely an independent contractor. If you have control over the means and manner of how a task is performed, pay a set amount per hour and use this person on a full time basis then they are likely to be considered an employee.

If you have workers that you currently treat as independent contractors but aren't sure of their correct classification please contact your Dermody, Burke & Brown advisor so we can help you with the analysis. If the scale tips towards employee the current IRS initiative may be a relative painless way to go forth and sin no more.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.