You may think the line between an employee and an independent contractor is a pretty clear one. Unfortunately, that is often not the case, and the IRS loves to try and get independent contractors classified as employees. That way, if they are successful, you as the business owner will be forced to pay withholding taxes, penalties and fees associated with not claiming somebody as an employee, sometimes going back many years. Employment tax controversies can cost huge dollars, and they can literally make or break a business.

Why the IRS is so aggressive about employee classification

Almost all taxes collected by the government are withheld from employees. Social Security, Medicare, FICA, and income tax withholding make up 80 to 90 percent of taxes collected. The IRS wants payers to withhold taxes at the paycheck source. Otherwise, they wouldn't be making any money, or at least, not enough to run the government.

If a freelancer doesn't pay his taxes, the IRS will instead go after those who pay him -- who they claim are his employers. They're looking for money, and they want the person who's paying the freelancer to pay up on the taxes, including income tax and Social Security. For them, this is just another -- the easiest -- avenue of collecting. If they can't collect taxes from one person, they'll go after another.

Employee classification can be a gray area

You may think that the guys who come to work but bring their own tools are independent contractors, but it can actually be a little ambiguous as to whether they're independent contractors or employees. Unfortunately, this gray area has the potential to apply to almost anyone you hire.

If you do things right from the start, you can make sure they're classified correctly and maximize your ability to have them classified as independent contractors, if that is what you want. Unfortunately, most employers aren't sure how to get independent contractors classified correctly.

One way to ensure that you're safe is to talk to a tax lawyer during the planning stages of your business. That way, he can let you know what options are available to you in this regard and help you set up your business to maximize your ability to claim you have independent contractors, rather than employees, working for you.

Situations where it could happen

There are many different "are they or aren't they?" situations that could happen to you. For example, if you hire somebody to do landscaping or construction for you, and you dictate the times they can work, but they bring their own tools, are they an independent contractor or an employee?

Liability can come in many forms as well. For example, you could be one of several business partners, one of who is supposed to "take care of the tax stuff." However, if he's taking care of it improperly, you could be in just as much trouble when the IRS comes knocking.

Even if your business is separately incorporated, or is an LLC, the IRS can go after you personally in these employment tax disputes.

And if you lose, not only do they get to collect the tax, but the penalties can be huge when employees are reclassified. As if that weren't enough, there's no statute of limitations if employment tax returns haven't been filed. That means you could be paying taxes and penalties on recently reclassified employees going back 10, 20 or even 50 years.

When the IRS starts knocking on your door

The IRS has special tools to force compliance when it comes to employment taxes. As dramatic as their enforcement powers are with regular income taxes, they have much more draconian mechanisms for enforcing employment taxes.

They can do a lot of damage just by asserting that you screwed up in this area. They can start levying on assets before the dispute is even resolved. The ends justify the means here, with a "you owe us the money, and we're going to start taking it" attitude. Most taxes are collected by forcing employers to pay.

They sometimes grab a bank account -- especially a payroll account -- before they show up, just to get your attention. They can go after anyone with any connection to the business: officers, owners, and anyone who can sign checks. Sometimes, they even go after bookkeepers. They go after all of them.

The first thing you should do if an employment tax dispute with the IRS arises is contact a tax attorney immediately and find out if it's something you can win. A tax attorney can help you see what your options are in this situation. You may not even be liable even though the IRS insists that employment taxes improperly haven't been filed or paid.

Dealing with litigation: you need a TAX lawyer

Hiring a tax lawyer is perhaps the most important decision you'll have to make when dealing with the IRS. If you hire a lawyer with insufficient training and experience, he can take your money and not even know what he's doing.

Most people go to accountants about tax problems. Unfortunately, accountants are not trained in how to handle real litigation. And they have only a very limited confidentiality privilege -- a huge problem in employment tax disputes, which have the potential to escalate into criminal problems.

Look for a lawyer who has a specialized degree in taxation, and preferably graduated from a nationally recognized law school like the NYU School of Law. You should also look at peer-reviewed ratings like those published by Martindale-Hubbell, or seek recommendations from judges and other lawyers.

Finding a tax lawyer who can help save your company

If the IRS wins a dispute about employment taxes, the results can be devastating. A company can go bankrupt, and you could even face criminal prosecution. You may also be liable for worker's compensation if you lose.

If the IRS comes after you for an employee tax dispute, get a tax lawyer immediately. If you find somebody who's knowledgeable and can stand up to them in court, you'll save yourself a lot of financial heartache, and you may even save your business.

About the Author
Clifford N. Ribner is a tax attorney in Tulsa, Okla. For more than 28 years, he has helped people with serious tax problems fight the government and win. If you're embroiled in IRS controversy and need somewhere to turn, visit him online at http://www.cnribneratty.com.