Payroll Audits Put Small Employers on Edge Tax Crackdown Comes as Use of Contract Workers Grows; Companies Find Rules Unclear

Angus Lotun & Emily Maltby for the Wall Street Journal write: Internal Revenue Service auditors showed up with little warning at Brian Robinson's staffing firm in Atlanta a year ago, seeking to verify that a dozen outside contractors he had hired to handle his information-technology services weren't, in fact, full-time staffers.  The audit was part of a government crackdown on employers who misclassify workers as independent contractors to avoid paying payroll taxes, and other employment-related expenses.

Mr. Robinson says the auditors ultimately found that his 30-year-old family business, TRC Staffing Services Inc., with its 100 permanent employees and up to 20 temporary workers, was in the clear. But he says the audit was "nerve wracking" because tax law doesn't make it easy to distinguish between full-time staff and independent contractors doing full-time work. He says the legal distinction can be confusing even for an employer with his decades of experience in the labor market.

The appeal of using outside workers is growing as many small businesses struggle to stay lean. Some employers also are turning to contractors to avoid hitting the 50-employee threshold that would require them to pay for employees' health insurance, starting next year, under the federal health-care law, or pay a penalty.

State studies have shown that local businesses misclassify anywhere from 10% to more than 60% of their workers as independent contractors. Many business owners blame the complex tax code, which doesn't offer black-and-white standards for telling the difference. The distinction is based on the employer's degree of control over a worker, the length of the relationship and a series of other factors. But such factors are open to interpretation. Past court cases on the issue have had different outcomes, providing little guidance.

In the past three years, the IRS, working with the Labor Department and officials in more than a dozen states, set a goal of investigating 6,000 employers, like Mr. Robinson, to ensure their workers are properly classified. Since September 2011, the government has collected $9.5 million in back wages for more than 11,400 workers who were misclassified as independent contractors by their employers, the Labor Department says.

The crackdown is aimed in part at boosting tax revenue. Employers don't pay or withhold income taxes, Social Security, Medicare or unemployment taxes for independent contractors, as they do for staff workers. The U.S. Treasury estimates that forcing employers to properly classify their workers—while tightening so-called "safe harbor" rules that provide them with leeway in determining who is and isn't an employee—would yield $8.71 billion in added tax revenue over the next decade.

Despite the threat of a payroll audit, more small employers are finding that independent contractors are essential to remaining competitive. The number of small firms that rely on outside contractors, for everything from technology services and public relations to marketing and sales, has grown sharply over the past five years, according to SurePayroll, a Chicago-based payroll-management firm whose clients are small employers.

The firm says that the proportion of contractors on the 80,000 small-business payrolls it processes every month has nearly doubled over past six years, rising to 6.7% last month from 3.4% in February 2007.

"As economic situations get tougher, that's when everyone is looking to cut costs," says Lisa Petkun, partner in the tax-practice group at law firm Pepper Hamilton LLP in Philadelphia. "It's significantly cheaper to have an independent contractor."

Using independent workers gives employers flexibility to hire only when there is work to be done, and leaves them with fewer tax obligations—and thus less paperwork—than do regular full-time workers. Using contractors also can cut benefits costs: they typically aren't eligible for such benefits as health insurance and paid maternity leave.

A Michigan State University study estimates that contractors can save employers as much as 40% on labor costs. Indeed, some business owners say the IRS audits could stifle their ability to grow as demand picks up.

"I'm either going to hire someone full-time to do a job or we just won't do it," says Ciaran Dwyer, chief executive of 3t Systems Inc., a Denver-based IT company with 65 full-time workers. His firm relies on about a dozen outside contractors at any given time, depending on demand, he says.

Rather than risk an audit, and perhaps costly penalties—Mr. Robinson, the staffing-firm owner, says many of his small-business clients are rushing to convert any long-term contract workers into permanent staff.

Mike Johnson, a human-resources manager in Atlanta with over 35 years of experience with small employers, ranging from commercial insurance to telecommunications firms, says a payroll audit is a major disruption for a small business. "Apart from the legal expenses, the downtime is just not worth taking the risk," he says.

In January, the IRS extended an amnesty program designed to encourage employers to voluntarily reclassify contractors as employees by waiving some penalties. Under the program, employers pay as little as 1% of the wages paid to their reclassified workers the previous year, rather than the full amount they owe in back taxes. So far, 1,000 employers have signed on since the program was launched in 2011, the agency says.

In recent years, Congress has proposed various bills to clarify the definition of independent contractors, including as recently as December, though none of the bills has passed.

Chris Whitcomb, tax counsel for the National Federation of Independent Business, a small-business lobbying group, says that without a clear definition of who counts as an independent contractor, many employers don't know whether they are complying with tax rules "until they get audited."