Nonprofit Accounting Basics

Payroll Taxes -- A Hot IRS Initiative -- With a Burning Question: Employee or Independent Contractor

The IRS will be selecting 500 nonprofit organizations for payroll audits in each of the next three years (as well as a high number of for-profit companies). This is an area the IRS believes it can collect a lot of unpaid taxes, interest, and penalties. Obviously, timely and accurate filings of payroll tax returns will be checked as well as up-to-date payroll and W-9 files. However, the biggest issue with the IRS will be proper classification of employee vs. independent contractor. It is tempting to classify a worker as a contractor in order to save payroll taxes and to avoid withholding of federal and state taxes, but without a firm basis for doing so, the penalties can be severe. Thus, it is an excellent time for organizations to assure themselves that their payroll houses are in order. In addition to being sure that files are in order and the payroll tax returns match the accounting records, a checkup on the rationale for any worker classified as independent contractor is an excellent idea. The organization may choose to do this internally or hire an outside consultant with expertise in this area. The IRS will apply a “facts and circumstances” approach to determine if an individual working for an organization is an employee or an independent contractor. The IRS bases its determination on control by the organization and degree of independence of the contractor. It looks at three categories in this regard: behavioral control, financial control, and the type of relationship between the parties. To assist with this analysis, the following list of questions may be helpful:

  • How much control/instruction is provided by the organization? Significant day-to-day control is indicative of employee status.
  • Can the contractor send in another person or staff to do the work? If so, contractor status is more likely.
  • Is this a continuing relationship? If the same work is done over a long period of time by the same person, employee status is more likely.
  • Is the person paid by the task or by the hour, week, or month? If by the task, contractor status is more likely.
  • Is the work done in the organization’s office or elsewhere? If done in the office, the IRS will lean toward employee status.
  • Who pays the person’s expenses and provides the needed tools or equipment for the work? If paid by the organization, employee status is more likely.
  • Does the person have several different clients vs. only working for the organization? Having several different clients is favorable toward contractor status.
  • Can the person easily be terminated or easily quit? If so, employee status is more likely.

None of these factors is the only determinant (read the IRS guidance for additional factors and examples), but rather, each should be considered as a building block for having a strong position one way or the other. Just having a contract with an individual (although highly recommended) that identifies the person as an independent contractor is not a guarantee the IRS will agree with the status—the facts and circumstances must back up that status. The IRS Website, http://www.IRS.gov, has a virtual course in its “Charities and Nonprofits” tab which provides a lot of information on this topic. Additionally, IRS Circular E ,which can be downloaded from the website at http://www.irs.gov/publications/p15/index.html, contains a significant amount of detail on this topic. As with most IRS initiatives, it is always better to be ready prior to an IRS inquiry. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Material discussed in this tax alert is meant to provide general information and should not be acted on without professional advice tailored to your organization’s individual needs.