*Because the IRS believes it can collect a lot of taxes, it is going to select 500 nonprofit organizations for payroll audits in each of the next three years (as well as a high number of for-profit companies).Obviously, timely and accurate filing 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 want to classify a worker as a contractor in order to save payroll taxes and to avoid withholding for Federal and State taxes. However, 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 house is in order. In addition to being sure that files are in order and that the payroll tax returns match the accounting records, a check on the rationale for any workers classified as independent contractors 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 employee is a contractor or not. 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 towards 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 towards contractor status.

• Can the person easily be terminated or can they 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 that 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 tabs 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/pub/irs-pdf/p15.pdf, 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.

*This article originally appeared in BDO USA, LLP’s “Nonprofit Standard Issue 23 (December 2010)“. Written by R. Michael Sorrells, BDO CPA. Copyright © 2011 BDO USA, LLP. All rights reserved. http://www.bdo.com