The IRS Is Watching Filings for Independent Contractors | Article

Outsourcing Aids Compliance

IRS is watchingHiring independent contractors directly is becoming a great way for companies to add just-in-time skillsets to their workforces. But this increasingly popular solution also creates a significant administrative burden and can expose companies to many legal risks if the employer-employee relationship isn’t clearly defined for each contractor.

Employers are responsible for properly classifying workers as W-2 employees or 1099 contractors. Misclassifying workers or failing to comply with state and federal labor laws puts them at risk of back taxes, penalties, and disqualification of employee benefit programs.

This challenge led JC Information Technology Services (JCIT), an IT consulting firm, to Delray Beach, Florida-based Yurcor, a business process outsourcing firm that provides back-office services for companies and staffing firms that hire independent contractors.

“We were spending so much time with compliance and consultant billing issues that it was intruding on our being able to satisfy our customers,” says John Costanzo, CEO of JCIT. His company develops and manages databases for a variety of IT companies and at any given time can have as many as five outside consultants involved with as many as 10 different projects.

“The issues of compliance regarding benefits and contract employee taxation have become so much more important for firms that contract their work out,” says Keith Widyolar, Yucor’s director of marketing. “Hiring contract employees has been very popular over the past decade, but in the late ’90’s these companies began seeing greater government scrutiny of these relationships.”

A Not-So Brave New World

The Internal Revenue Service has been cracking down on contractor noncompliance more aggressively for the last 10 years. Microsoft settled its well-known “permatemp” case in December, 2000 when it agreed to pay $97 million in the eight-year-old class-action lawsuit brought by permatemps. Permatemps claimed Microsoft illegally avoided paying benefits like pensions and healthcare. In another similar case, a judge ordered AOL to pay $5 million in damages and non-compliance penalties.

In addition to the IRS onslaught, many states are redoubling their efforts to identify contract employees (and their employers) who are not reporting income properly for state tax purposes. An internal memo from one New York company recently mentioned that there were at least seven pending audits of IT staffing companies by the state, all of them concerning employee classification relative to tax reporting.

This oversight has come not only in the area of tax classification, but also employee benefits. Federal and state Departments of Labor are clamping down on companies that don’t pay full-time contract worker benefits. An initial appeal of hiring contract labor was a company’s apparent relief from the benefit obligation. But several rulings over the past few years have determined that contract employers must now offer the same benefit opportunities to their full-time contract workers as regular full-time employees.

Companies that use a lot of contractors are discovering that their backoffice can be quickly overwhelmed with the flood of contracts, invoices, payments, tax compliance issues, benefits and collection inquiries that contractors generate.

A New-Age Solution to a Thorny Problem

“A lot of companies are looking for third-party validation when it comes to compliance issues,” says Carrie Lewis, senior analyst, Technology Management Strategies for The Yankee Group, a Boston, Massachusetts consulting firm. “Even though they’re ultimately responsible for taxation and benefits to their contract employees, a third-party firm that manages these issues can have a positive impact on their back office.”

Yurcor provides many of its services online and handles all the compliance paperwork associated with contractor relationships, benefiting both contracted employees and the companies that use them. Its services include 1099 compliance testing to determine compliance risk; consolidated invoicing (which means contractors don’t have to knock on clients’ doors for payment anymore), healthcare benefits and even direct deposit of contractor fees.

These services are Web-accessible for both contractor and employee. This approach allows companies to determine their compliance risks in real time, reduce the cost of using contractors and in many cases, eliminate compliance risks altogether.

But there’s another dividend for client companies. Some firms are able to use Yurcor’s Web-based monitoring system to track the work that contractors are performing, also in real time. “I have my contract employees enter their time and project every day,” says JCIT’s Costanzo. “And my clients can review those hours on the Yurcor site to get a precise understanding of who is doing what and what the billing will be,” he says.

“Some firms may not know how many contractors they’re using at any given time or how much they’re spending,” he explains. “Contractors don’t come in through a central gateway, like employees do when human resources hires and processes them. Each department usually employs them for a specific time and the paperwork typically goes up the line to HR.”

Putting Contractors and Employees on the Same Page

One of Yurcor’s services is protecting companies from the 10 percent penalty fees on back taxes they could wind up paying if found noncompliant. That’s quite appealing to companies that employ many contractors.

Additionally, Yurcor offers a Life Cycle Management program for contractors. Those who participate in the service find that it provides cost advantages of 1099 consolidated invoicing and eliminates compliance risk by converting 1099 contractors into W-2 employees of Yurcor. This helps eliminate tax headaches and offers the security of portable corporate-style health and retirement benefits.

JCIT’s Costanzo is a recent convert to this program. And he is beginning to see a positive impact on his firm. “I figure Yurcor’s entire service is saving about 20 percent of my backoffice resources and at least 10-15 percent in direct monetary costs,” he reports.

The Yankee Group’s Lewis isn’t surprised. “With greater emphasis being placed on these issues of contract employee taxation and benefits compliance, a third-party outsourcing expert also provides peace of mind. It’s quite unpleasant having to deal with compliance issues from a position of weakness.”

Lessons from the Outsourcing Journal:

  • Government agencies are placing greater emphasis on compliance for contract employee relationships. This additional responsibility often places a strain on employer backoffice processes.
  • The costs of non-compliance include back taxes and penalties, disqualification of employee benefit programs, legal fees to defend compliance and negative publicity.
  • Since the length and nature of contract employee relationships varies depending on the company and the project, a compliance outsourcing consultant can help develop a standard set of practices when managing contract employees, thereby eliminating ambiguity and creating uniform consistency.


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