It has been said that the American dream used to be owning your own home. Today, there are many who say the new American dream is owning your own business. With the incredible growth of the independent workforce and client companies increasingly seeking out subject matter experts to perform project work, many of these new entities are businesses-of-one. With this growth has come increased scrutiny by the IRS of tax returns and worker classification.
This new American dream is based on the belief that any individual with a smart idea can build a business that leverages their experience and skillset. With determination and hard work can create a thriving business and exciting new career path for themselves.
Being your own boss (sometimes called a “solopreneur”) is legally referred to as being an independent contractor. This worker classification is at the heart of the new American dream. Many successful independent contractors eventually grow their small business into a larger company that employs others, creating jobs and securing a good life for those who also believe in hard work and determination.
America is still the land of opportunity. And the ability to make a living by working for yourself is the core of what makes America great. However, there are a few potholes along the road to achieving The American Dream…
The IRS often targets tax returns of self-employed individuals for audits
Self-employed Americans and the workers they hired accounted for 44 million jobs in 2014, or just over 30% of the US workforce, according to a Pew Research Center analysis of data from the U.S. Census Bureau.
The US Internal Revenue Service (IRS) conducts regular examinations (or what we would call audits) of tax returns to determine if income, expense, and credits are being reported accurately. The IRS enforces the federal tax law in a number of ways; the more common methods include correspondence (examination by mail) and field (face-to-face audit) examinations. In the most recently reported tax year (2014) the IRS audited 0.7% of the 190 million total tax returns filed (which includes over 24 million tax returns from sole-proprietorships, representing over $1.3 Trillion in gross revenues). While this audit percentage may seem like a small number, it still represents nearly 1.4 million audits. Many of these are targeting self-employed taxpayers who file a Schedule C – and self-employed individuals almost always file a Schedule C.
Justifications for targeting Schedule C filings
The IRS cites two major justifications for targeting taxpayers with Schedule C filings:
1. Exaggerated business expenses claimed by many IC’s
The IRS has consistently found that claimed business expenses are often significantly overstated. These claims, in turn, result in underreporting income and therefore become a source for additional tax assessments during an audit. Common examples include:
- Home office space not used exclusively for business
- Non-business mileage (i.e. vehicle mileage for personal use)
- Subcontractor expenses
- Travel, meals, and entertainment expenses
- Line 27 “Other Expenses”
2. Potentially misclassified workers
The IRS is also looking for individuals who should, in reality, have been the employee of a company. This is the classic case of a worker who has been misclassified as an independent contractor yet is in reality doing the work of, and being managed like, an employee.
If the IRS determines that the self-employed individual did not qualify for independent contractor status and should have been classified as an employee, the individual in question will not be allowed to claim expenses on a Schedule C. These expenses, in turn, will be disallowed as will any contributions the individual made to a pre-tax retirement plan they may have established. Furthermore, the IRS will also likely investigate the entity on the receiving end of the services performed to ascertain if they acted as the employer.
If the individual gets audited, so can their client companies
An audit of an individual who has operated as an independent contractor performing services for client companies is a slippery slope. In many cases the IRS may use the disqualification of independent contractor status for an individual as the justification for auditing a company. If the IRS finds that a misclassified worker has provided services exclusively for a single company, they will often elect to audit that company looking for more workers who have operated the same way. The greater the estimated revenue an audit can potentially produce, the greater the possibility the company will be audited.
Companies that utilize large numbers of independent consultants are at a higher risk of being selected for a so-called “backdoor audit.” Once the IRS selects a company for this audit, the inquiry may extend to any source the auditor believes could produce additional revenue. In other words, the audit may not be limited to just payroll taxes. In many cases an IRS audit will also initiate a state audit since the IRS has a number of agreements with state agencies to share data. Causing further trouble for the audited company is the common scenario of an aggressive plaintiff’s attorney pursuing a class-action lawsuit on behalf of the workers.
In the final analysis, both a client company and the individual who is performing services are exposed to an increased audit risk when the worker files a Schedule C with their federal tax return. This is just one of many triggers for an IRS audit of not only an individual but also for the entire company. At TalentWave our job is to help our clients safely and cost-effectively engage independent workers while protecting them from worker misclassification risks. While it is perfectly legal for workers to be classified as independent contractors, it is very important that the workers, and the work, is evaluated and set up correctly. It pays to have an expert on your side.