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IRS Compliance Checks

Learn how to navigate an IRS compliance check for independent contractors and classify workers properly for payroll tax purposes.
January 1, 2001
URL: http://www.entrepreneur.com/article/35928

Q: The IRS recently contacted my business to perform a "compliance check" of the W-2s and 1099s I filed. The agent indicated this wasn't an audit, but rather they would only be looking at the IRS forms my business had filed. What are they looking for and should I be concerned?

A: The IRS is most likely looking for workers you've classified as independent contractors. The government contends that it loses millions, quite possibly billions, of dollars each year on workers who've been classified as independent contractors but who haven't voluntarily paid self-employment taxes.

As you know, when a worker is classified as an employee, the IRS receives both the employer and employee portion of payroll taxes directly through the payroll tax withholding system. Their concern is that many businesses classify workers as independent contractors when they're actually employees. But before we get into classification of employees for employment tax purposes, I want to address your question about compliance checks.

The IRS's stated purpose for compliance checks is to educate taxpayers and encourage compliance. Compliance checks are clearly different from examinations or audits since the IRS isn't trying to establish tax liability. When they initially contacted you regarding the check, the IRS should have told you this wouldn't be an audit and that they'd be limiting the scope of their check only to IRS documents. If you've been contacted for a compliance check, you should probably let your accountant-and if appropriate, your attorney-know.

During a compliance check, the IRS shouldn't be examining your books and records; rather they should be reviewing only IRS documents. Additionally, they shouldn't ask how you determined whether a W-2 or 1099 should be filed. To learn more about compliance checks, go to the IRS Web site and search the term "compliance check."

The compliance check has proved to be a valuable IRS tool for rooting out misclassified workers. During a compliance check, cooperate with the agent, but be precise in responding to his or her requests. Keep in mind that the IRS's Employment Tax Handbook states that "the examiner generally should be able to secure the information in one or two contacts with the taxpayer. If more than two contacts are necessary, an examination should be opened." The last thing you want to do is trigger a full-fledged IRS audit with uncooperative behavior.

Laura A. Collins is a CPA and freelance writer with more than 18 years' experience in finance and taxation. She writes from her home in Greensboro, North Carolina.


The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.

Classifying Workers

The independent contractor issue has been batted around for years. Independent contractors are a hot issue for the IRS because the potential for an agent to raise considerable revenues is significant. If you have no reasonable basis for classifying an employee as an independent contractor, you may be held liable for employment taxes for that worker-and not only the employer portion of the payroll taxes, but the employee's portion as well. You can also be charged penalties and interest.

Resource Guide

Don't let compliance checks scare you away from using independent contractors. Read Hiring An Independent Contractor for more information on this taxing topic.

Plunge into the world of small-business taxes with

Tax Savvy For Small Business: Year-Round Tax Strategies to Save You Money, 4th Edition by Frederick W. Daily
Tax Guide 2001: CCH Business Owner's Toolkit by Susan M. Jacksack
Finance and Taxes for the Home-Based Business by Charles Lickson and Regina Preciado
J.K. Lasser's Taxes Made Easy for Your Home-Based Business by Gary W. Carter

Establishing whether a worker is an independent contractor or not comes down the facts and circumstances of the worker's relationship to your business. Rather than going through a litany on the 20 common law factors (which can be found in IRS Publication 15a) for determining a worker's status, I'll focus on the two central issues addressed by these factors-control and risk.

Control basically boils down to whether you tell the worker when to show up, what to do, how to perform, what sequence the work is to be performed, and/or if you provide training relative to the work. Risk involves whether:

The bottom line is this: If a worker isn't hanging out their "shingle" to perform the same duties for others, it'll be difficult to classify that person as an independent contractor. Workers who actively manage their own business where you don't exercise control over their "comings and goings" will most likely qualify as independent contractors. It's the gray area in the middle where most businesses get into trouble.

The IRS definitely has a bias toward classification of workers as employees. Caution should be exercised when classifying virtual employees as independent contractors. But when you have a legitimate basis for classifying a worker as an independent contractor, go ahead.