IRS Audit Red Flags, Part II

One of a CPA’s priorities is keeping their clients off the IRS “naughty” list, and I wanted to share some more IRS Audit Red Flags with you,

Audit Red Flags, Part Deux

I.  Independent Contractors

II.  S Corps (the S stands for $)

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I.  Independent contractors:

                If you have employees, employers need to pay FICA tax, Federal withholding, and Federal unemployment every paycheck.  When employers hire independent contractors, these requirements (and others) disappear.  The business owner is required to file a 1099-MISC and send it to the IRS at the end of the year.  When workers choose to be classified as independent contractors, the IRS is shortchanged in two ways because independent contractors can

1.        Deduct on their tax return many items that would otherwise be considered personal:  travel, entertainment, office supplies, insurance, home office expenses.  This could reasonably amount to 20% of one’s income

2.        Set up their own pension plan, which is deductible against their income

                Two catches for independent contractors is they must pay their own FICA tax, and pay withholding tax on their net taxable income

IRS Methods to reclassify independent contractors to employees:

  1. Control of behavior (instructions and directions)
  2. Control of finances (financial risks of the worker and opportunities for profit)
  3. Relationship of employer and worker (how they view each other in their written contract.

How to protect yourself...?

Draw up a foolproof independent contractor agreement

  • Specify the services to be rendered
  • Insert a starting and completion date
  • Make sure the independent contractor is controlling the procedures necessary to accomplish the agreed upon services
  • Make it clear the contractor is in charge of how the project will be completed
  • Indicate that all insurance, liability, fire and theft, will be provided by the independent contractor
  • Payment methods should be sporadic and vary over time
  • Do not separately state an allowance for overhead costs, they should be included in the contract price
  • Spell out that training is responsibility of the contractor
  • Do not promise the contractor office or working space on the owner’s premises
  • Avoid paying a bonus or any fringe benefits such as vacation or medical insurance.
  • If work slows down, the project may not continue

Do not fill out W2-s, don’t give even limited benefits, and have them fill out a W9 form, by signing the W9, the contractor agrees to pay all necessary taxes.

 II.  S corporations

An S corporation is an organization that offers its owner the advantages of a corporation along with the favorable tax treatment of the sole proprietorship or partnership.

The annual net income or loss of an S corp passes through to each shareholder’s 1040 on one line, Schedule E.  Accordingly, no income or expense detail shows up on the 1040.  You immediately avoid all the targets, triggers, and special programs that the IRS currently has in place to bring attention to taxpayers who file Schedule C

Corporate income reporting requirements are entirely different. 

Sources:

Martin S Kaplan, CPA, What the IRS doesn’t want you to know, 9th Edition, Wiley & Sons, 2004