IRS Form 1099 Reporting: “Audit Proofing” Your Business

» Articles » Tax Articles » Article

August 08, 2018
Author: Lorman Education

Businesses that issue Form 1099 due to the employment of independent contractors can often have a higher risk of being audited. This is due to the fact that the wages paid are deductible expenses; a significant number of deductions may trigger an audit, especially if a business is consistently reporting a loss due to these deductions.

Additionally, many independent contractors are unaware of the fact that they need to pay taxes on wages reported on Form 1099, and many times they will attempt to persuade the I.R.S. to classify them as an employee, thereby triggering an audit of the employer.

Although you can’t prevent an audit from occurring, you can prepare yourself by creating a trail of documentation which verifies an individual’s status as an independent contractor as opposed to an employee.

Continue reading below

FREE Tax Training from Lorman

Lorman has over 37 years of professional training experience.
Join us for a special white paper and level up your Tax knowledge!

Miscellaneous 1099 Issues
Presented by Jennifer A. Driskill CPA, M.B.A.

Learn More

Employment Agreements

With the advent of online companies which provide legal documentation at a reduced rate, as well as a wave of business’s and individuals creating legal documents for themselves based upon information that they find via brief research, many employers are utilizing employment agreements which lack important details. Even worse, some employers are operating off of oral agreements, and thus have only their word and a paper trail of payments to rely upon in an audit.

It is best to create a detailed employment agreement which identifies the contracted party as an employee or independent contractor. However, it is not enough to merely use the term “employee” or “independent contractor” in the agreement. Rather, enough details about the scope of employment must be provided so as to satisfy the elements of employee or independent contractor status.

As an administrative agency, the I.R.S. has a fairly large amount of discretion when determining how to classify a person’s employment status. Nonetheless, there are three relatively specific guidelines that the I.R.S. will look to in making this determination. The factors considered within these three guidelines should be detailed as explicitly as possible within employment agreements.

1. Behavioral Control

Behavioral control refers to whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done; the employer only needs to possess the authoritative ability to exercise its right to direct and control the work.

a. Types of Instruction Given

Employees are generally subject to the business’s instructions about when, where, and how to work, whereas independent contractors are not. The following are examples of types of instructions about how to do work:

_ When and where to do the work.
_ What tools or equipment to use.
_ What workers to hire or to assist with the work.
_ Where to purchase supplies and services.
_ What work must be performed by a specified individual.
_ What order or sequence to follow when performing the work.

b. Degree of Instruction

The more detailed the instructions, the more control the business exercises over the worker. More detailed instructions will result in a determination that the worker is an employee. Less detailed instructions reflect less control, and thus will result in a determination that the worker is more than likely an independent contractor.

The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct specialized professionals, so the amount of control needed to classify a worker as an employee in such a situation may be less. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

c. Evaluation System

If there is an evaluation system in place which measures the details of how the work is performed, then these factors would suggest that the worker is an employee. If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee; the ultimate outcome will depend upon a review of all other factors as a whole.

d. Training

When a business provides a worker with training on how to do the job, this suggests that the business wants the job done in a particular way. This will invariably be viewed by the I.R.S. as strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship, as this indicates that the worker’s employment is an ongoing relationship.

2. Financial Control

Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job.

a. Significant Investment

An independent contractor will often have a significant investment in the equipment used in working for someone else. However, in many industries, such as construction, workers spend thousands of dollars on equipment they use, yet they may still be classified as employees.

There are no precise dollar limits that must be met in order to have a significant investment. Additionally, a significant investment is not required for independent contractor status; some types of work simply do not require large expenditures, and thus not all independent contractors can reasonably be expected to incur significant investment costs.

b. Unreimbursed Expenses

Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.

c. Opportunity for Profit or Loss

The opportunity to make a profit or loss is another important factor. If a worker has a significant investment in the tools and equipment used, and if the worker has unreimbursed expenses, then the worker has a greater chance of their expenses exceeding their income from the work. Having the possibility of incurring a loss suggests that the worker is an independent contractor.

d. Services Available to the Market

An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market. Employees, on the other hand, may often have clauses in employment agreements which prevent them from providing their services to competitors.

Additionally, due to the specific hours at which employees are required to appear for work, it is virtually impossible for an employee to be able to provide their services to other businesses. Independent contractors, on the other hand, are often given basic tasks to complete and are given a deadline by which to complete the task; such work scheduling often allows them to seek out other business opportunities and provide their services to other employers.

e. Method of Payment

An employee is generally given a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid with a flat fee per job or task. However, it is common in some professions, such as law and accounting, to pay independent contractors hourly.

3. Type of Relationship

The type of relationship element refers to facts that show how the worker and business perceive their relationship to each other. When a business uses specific terminology in a contractual agreement (such as referring to the worker as an employee), or when the business confers certain benefits to the worker that may be indicative of an intent to establish the worker’s status (such as giving a pension plan to an employee), this can be used to help classify the worker.

a. Employee Benefits

Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.

b. Permanency of the Relationship

If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the worker is an employee.

c. Services are Key Aspect of Business

If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate that the worker is an employee.

The material appearing in this web site is for informational purposes only and is not legal advice. Transmission of this information is not intended to create, and receipt does not constitute, an attorney-client relationship. The information provided herein is intended only as general information which may or may not reflect the most current developments. Although these materials may be prepared by professionals, they should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.

The opinions or viewpoints expressed herein do not necessarily reflect those of Lorman Education Services. All materials and content were prepared by persons and/or entities other than Lorman Education Services, and said other persons and/or entities are solely responsible for their content.

Any links to other web sites are not intended to be referrals or endorsements of these sites. The links provided are maintained by the respective organizations, and they are solely responsible for the content of their own sites.