The Internal Revenue Service is joining with more than two dozen states in an intensified effort to crack down on employment-tax violations. Among the key issues is whether a worker should be classified as an employee or an "independent contractor" -- a difference with significant tax implications for both businesses and workers.The IRS recently signed information-sharing agreements with state labor or work-force agencies in 29 states, including California, New York, Michigan and Ohio. Combining resources will help the IRS and the states "reduce fraudulent filings, uncover employment tax avoidance schemes and ensure proper worker classification," said Kathy Petronchak, head of the IRS's small business/self-employed division. 

Employers generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. But they generally don't have to withhold or pay taxes on payments to independent contractors, the IRS says. If an employer incorrectly classifies an employee as an independent contractor, it can be held liable for employment taxes for that worker, plus a penalty, the IRS warns. 

Figuring out the difference between an employee and an independent contractor can be very tricky. The IRS provides this rule of thumb: Anyone who performs a service for you is your employee "if you can control what will be done and how it will be done." That's the case "even when you give the employee freedom of action," the IRS says. "What matters is that you have the right to control the details of how the services are performed." 

The complexity of worker classification "has long caused headaches for many businesses," says Elizabeth Milito, a lawyer for the legal foundation for the National Federation of Independent Business. She says Congress should be focusing on developing a "clearer and simpler" definition of an independent contractor. But despite some lawmakers' proposals to overhaul the law, Congress hasn't acted. 

The IRS-state initiative goes well beyond worker-classification issues. It aims to detect businesses attempting to avoid employment-tax obligations "by operating in the underground economy and making cash payments to workers and not reporting those payments to the IRS and to the states," says Robert Affleck, deputy director, tax branch, of the California Employment Development Department. 

That could be an important factor in narrowing the nation's "tax gap," or taxes that are owed each year but not paid. IRS officials have estimated the overall tax gap at about $290 billion.State officials say they have high hopes for the new initiative. California's Employment Development Department said the "memorandum of understanding" with the IRS "provides, for the first time a centralized and uniform mechanism" for the two agencies to swap employment-tax data. 

Michigan has "already begun to forge a much closer working relationship" with the IRS, which has "significantly increased the sharing of tax and audit information between the IRS and our unemployment insurance program," says Keith W. Cooley, director of Michigan's department of labor and economic growth. 

The states that have joined so far are: Arizona, Arkansas, California, Colorado, Connecticut, Hawaii, Idaho, Kentucky, Louisiana, Maine, Massachusetts, Michigan, Minnesota, Nebraska, New Hampshire, New Jersey, New York, North Dakota, Ohio, Oklahoma, Rhode Island, South Carolina, South Dakota, Texas, Utah, Vermont, Virginia, Washington and Wisconsin. 

As federal and state agencies share more information, "businesses are going to be held to a higher standard, and that's going to have an impact" on both employers and workers, says Scott Mezistrano, senior manager of government relations at the American Payroll Association in Washington.

Source: Paul Axelson
Internal Revenue Service