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IRS and State Auditors Attack Independent Contractors

Employee vs. Independent Contractor Status is a hot area of IRS Audits.

The state taxing agencies, as well as the Departments of Labor (which are responsible for Unemployment tax collections) have been stepping-up their audit activities. The purpose of the audit is to misclassify a subcontractor as an employee. The taxing agency can then collect the taxes which "should have been withheld" as well as large fines, penalties and interest. Since a significant portion of the taxes are so-called Tust Fund monies, the IRS and States hold the shareholders, officers or other Responsible Parties personally liable for the taxes.

Planning makes the difference between winning and Losing!

You should immediately contact your tax lawyer to prepare the Independent Contractor Contracts, Checklists, and other information needed to have the subcontractor status stand up to an audit. The facts of the relationship must also strongly support non-employee status. At a minimum, you can not exercise dominion and control over the work of the contractor. You can specify "what" is to be done but not "how." Other important factors in determining independent contractor status:
  • Does the subcontract use his/her own tools. equipment and other capital items
  • Does the contractor have a business telephone number and yellow page listing
  • Does the contractor have a business card, letterhead, invoices, and other printed items.
  • Does the contractor file tax returns (such as the 1040 Schedule C.)

The Subcontractor should establish an LLC!

If the contractor operates as a corporation or Limited Liability Company, the worker will most-likely be classified as an independent contractor rather than an employee. Even though it may be legally possible for an IRS or State tax auditor to ignore the corporation or LLC, most frequently the auditor will not challenge independent contractor status of a corporation or LLC.

The LLC is Best

At one time, establishing an "S" corporation was the best choice for proving subcontractor status. Now, with the advent of single member Limited Liability Companies, the LLC is the superior choice. Since the worker is filing a 1040 Schedule C anyway as a sole proprietor, and will also file a 1040 Schedule C as a single member LLC, other than the small cost of formation, the LLC is not detrimental to the worker and strongly asserts the worker's independent status.

Why is the LLC the best protection of the Subcontractor Arrangement?

The reasons why Limited Liability Companies and Corporations are usually affirmed in audits as subcontractors:
  • The LLC or Corporation is a separate legal entity distinct from its owners
  • The LLC only operates through its managing members and the Corporation through its directors and officers.
  • Corporate Officers are employees of the Corporation not the Business being audited for employee / independent contractor issues.
  • The LLC requires the filing of a 1040 Schedule C
  • The corporation will issue a w-2 to the shareholder as an officer or director, and the LLC member will pay self-employment tax
  • The business being audited therefore would not have to issue W-2's because they were issued by the worker's corporation or the Schedule C was filed for the LLC
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