If you treat employees as independent contractors and fail to withhold taxes the IRS can reclassify them and assess potentially crippling retroactive penalties. There are other consequences too.

Are you a small business owner? Do you have any “independent contractors”? Really? Then, watch out!

The IRS is looking for revenue. Surprised? Don’t be.

If you use independent contractors, then you might need to exercise a bit more diligence. Why, the IRS may consider them to be “employees” masquerading in a tax-cheating disguise.

It’s quite common for small business owners to rely on independent contractors, especially in lean times. And, from the perspective of the IRS, the difference can be huge in tax and legal terms. Why? An employer doesn’t have to withhold taxes or pay any benefits (instead, the worker pays a self-employment tax.). Unfortunately, some business owners intentionally classify workers inaccurately… and the IRS is working to prevent it in several ways.

However, the IRS isn’t the only one on the worker classification campaign. Forbes has a series of recent articles to keep us informed. Robert Wood has paid special attention to the issue, reporting here that the IRS has updated its SS-8 Form to inquire about the employee classification and it is slanted more heavily toward the classification of “employee” versus “independent contractor.”

The threat of improperly classifying a worker is always that the IRS will “reclassify” them, enforce penalties, and demand the back taxes on that classification. Nevertheless, this too may become more difficult and even more of a threat. In another article, Woods points out how recent examples indicate that the IRS is working far more closely with the Department of Labor and state governments to evaluate worker classifications. As a result, the consequences of an IRS reclassification also could mean unwanted attention from those bodies as well.

Finally, the IRS has started the Voluntary Compliance Settlement Program (VCSP) to give employers incentive to come forward and reclassify. In exchange, the IRS is offering a reduced penalty of a flat 10% on all employment tax liabilities for the past year. Note: This includes both the employer and the employee sides of Medicare and Social Security taxes, since the employer would have had to withhold the employee side from the employee’s pay in the first place. Stephen Dunn reports on that development here, along with the suspicion that it is actually an illusory classification program, since the IRS doesn’t have a leg to stand on in that effort.

Hopefully, you don’t have anything to hide. Who wants any extra attention from the IRS?

Reference: Forbes (September 21, 2011) “IRS, DOL and State Mount Independent Contractor Attack”; and (September 27, 2011) “Employers Beware of  IRS’  Illusory Worker Classification Program”