How To Avoid An IRS Worker Classification Audit

When a Sacramento entrepreneur founded their startup business in 2015, they hired a last-minute worker to serve as a graphic artist under an independent contractor classification. One day the Sacramento entrepreneur received an audit notice from the Internal Revenue Service about their misclassification of the worker. 

Do not get yourself trapped in the same dilemma. There are ways to protect yourself as a business owner and justify independent contractor classifications. In any business, the first thing that you must ensure is that a written contract exists. When complications arise, this binding document should be able to support your case, so make sure that you lay out the specific terms, for example, on the contractor’s responsibilities.  

Important note: the contract should give the contractor the liberty to get his or her own assistants as this is a factor that the IRS considers in classifying a worker.  

Ensure that the independent contractor can provide his or her own equipment and facilities required to deliver the services. Clarify that they can also offer their work to other businesses if they wish to do so. The wage for the service rendered should depend on the job instead of the hours, weeks, or months they delivered it. You can also require them to submit invoices before you give them the payment.  

Do not forget to ask for the independent contractor’s insurance and business license. Cautious provisioners of 1099’s even encourage their independent contractor recipient to report the 1099 income on their tax returns.

Now let’s go into payroll taxes–one of the costly inconveniences employers want to escape. As a business owner, you must withhold federal income taxes and social security and medicare contributions from your employees’ paychecks every payroll period. 

Of course, employers are tempted to avoid the hassle of withholding and remitting payroll taxes by classifying their workers as independent contractors rather than employees. However, in doing so, they may face a payroll tax audit from the State of California or IRS.

If you are unsure how much should be deducted, refer to Form W-4 of the employee that states the exemptions they declared. You should match the medicare and social security contributions depending on the gross earnings of the employees.  

Payroll taxes are deposited through the Electronic Federal Tax Payment System weekly, monthly or quarterly, based on the payroll size. Apart from this, you also need to submit the following to the IRS: 

  • Employer’s Quarterly Federal Tax Return (Form 941) is filed quarterly and indicates the total amount of federal income tax and your employees’ contributions from the previous quarter.  
  • Employer’s Annual Federal Unemployment Tax Return (Form 940) is filed once every year and shows the sum of your payroll tax deposits for all the quarters. This amount includes a federal unemployment tax paid for by your business and should not come from your employees’ paycheck.  
  • Form 944 is filed every year in case your payroll tax liability is less than a thousand dollars. If you submit this form, you do not need to file Form 941 anymore.