IRS Audits to Find Employee Misclassification and Lost Tax Dollars

Published November 2009

Although employee misclassification itself is not a violation of law, it is often associated with labor and tax code violations. These misclassifications cause the government to miss out on large amounts of tax revenue that it could put to use. For example, in the tax year 1984, the Internal Revenue Service estimated that U.S. employers misclassified a total of 3.4 million employees, resulting in an estimated revenue loss of $1.6 billion (in 1984 dollars). The Department of Labor commissioned a study in 2000 that found that 10 percent to 30 percent of firms audited in 9 states misclassified at least some employees. 

The IRS primarily enforces worker classification compliance through examinations of employers but also sometimes offers settlements in which eligible employers under examination can reduce taxes if they maintain proper worker classification in the future. The IRS provides general information on worker classification through its publications and fact sheets available on its website and also by working with tax and payroll professionals. Two helpful links to the IRS website regarding employee classification have been included at the end of this article.

Finding worker misclassifications is not only important for the government but it also helps to level the playing field for businesses. This ensures that employers are paying the correct amount of taxes for the workers they employ. Otherwise businesses with honest and responsible practices could be undercut by competitors who use misclassification to avoid paying the proper taxes or provide better benefits to hire and keep the best employees. Uncovering misclassifications also helps workers who don’t know the laws that are meant to protect them or may not be paid properly for overtime.

In response to all of these factors pushing to find misclassifications, the IRS has decided to audit 2000 US companies each year for the next three years as part of this initiative. According to the IRS, there is very little that companies can do to avoid being targeted because selections will be made randomly. Once a company is selected, they should expect the employment tax audits will be very detailed and will very likely cover more issues than worker classification.

IRS webpage – Independent Contractor or Employee?

IRS webpage – Employment Taxes and Classifying Workers