Internal Revenue Service is one group you don’t want to get noticed by but if you are misclassifying employees then expect a visit sooner than later.  The IRS auditors are cracking down on employers who misclassify workers as independent contractors to avoid paying payroll taxes, and other employment-related expenses. The legal distinction can be confusing even for employers with decades of experience under their belt. 

The appeal of using outside workers versus employees is growing as many small businesses struggle to stay lean. Some businesses are also using contractors to avoid hitting the 50-employee threshold that would require them to pay for employees’ health insurance, starting next year. State studies have shown that local businesses misclassify anywhere from 10% to more than 60% of their workers as independent contractors. The complex tax code detailing the difference between an employee and a contractor can be complex and unclear making it difficult for business owners to understand. 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 and many factors are open to interpretation. Past court cases on the issue have had different outcomes, providing little help.

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 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 would yield $8.71 billion in added tax revenue over the next decade.

None the less, 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.

To ease the pain for businesses to comply, 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.