The Department of Labor (worker rights), the Internal Revenue Service (income tax matters), and the States (unemployment insurance and workers compensation) have stepped up their enforcement activities in an economy in which employers are using contingent workers to save costs.

For example, last year, the IRS began a three-year national audit of 6,000 businesses under its National Research Program. The IRS says its audit targets will be selected at random. The audits will cover five employment tax-related issues: worker misclassification, fringe benefits, non-filers, officers' compensation and employee expense reimbursements.

That it's now become a political issue is evidenced it the attention President Obama gave to employee classification issues is evidenced in his recently proposed budget.

Roger Banham, contingent workforce compliance expert, reported on his blog that President Obama Proposes to Increase Spending for IC Compliance and Misclassification Enforcement in 2012. He says,

"This proposed funding is consistent with his often stated goals of closing tax gap loopholes and tightening enforcement on the misclassification of independent contractors. Politicians, at all levels of state and federal government, like to refer to tougher enforcement of IC Compliance as 'Leveling the Playing Field for employers."

Whether a worker is correctly classified is based on the facts and circumstances of the situation, taking into account the amount of degree and control maintained by the employer.

The IRS' online resource page, Independent Contractor (Self-Employed) or Employee?, discusses the three categories that provide evidence of the degree of control: 

• Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
• Financial: Are the business aspects of the worker's job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
• Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

It's not always obvious in making that determination, and it's not just large employers that are subject to scrutiny. Even small companies can get audited which Debbie Fledderjohan writes about in her blog post, Six Common Triggers for an IRS Misclassification Audit:

1. The 1099 Independent Contractor (IC) files an unemployment claim. This creates suspicion because they are not eligible for unemployment.
2. The 1099 IC files a workers' compensation or disability claim against the company. If someone is truly an IC, they should carry workers' comp and disability insurance on themselves because they are not eligible through an employer.
3. A worker receives a W-2 and a 1099 Form from the same employer in one year. This happens when they are converted from a 1099 IC to a direct-hire of the company.  But if they performed the same work as a 1099 IC and a W-2 employee, the IRS may wonder why they were not classified as an employee all along.
4. The worker files a complaint with the Department of Labor's Wage and Hour Division. With all the information out there about misclassification, workers are more savvy than your clients may think and can blow the whistle if they think they have been misclassified.
5. The worker feels they are being improperly treated as a 1099 IC and files a Form SS-8 with the IRS for their own classification determination or files a Form 8919, Uncollected Social Security Tax and Medicare Tax on Wages, with their personal income tax return.
6. The IRS is anonymously alerted about the worker or the employer not paying taxes.

But what if you make a mistake and that independent contractor is really an employee. How do you fix it? Here's how. There are two aspects to the fix.

From the retirement plan standpoint, you can use one of the correction programs offered by the Internal Revenue Service as part of their Employee Plans Compliance Resolution System (EPCRS). From the payroll tax standpoint, Accounting Web provides valuable Tips For Reporting Misclassified Employees. Not fixing it can be extremely expensive.

But the best way to avoid employee misclassification issues is to take prevention measures. Here are two suggestions for employers:

1. Review and update worker classifications on a regular basis.
2. Audit the status of each worker on a least an annual basis.

Bottom line (and there definitely is an impact on the bottom line): This is another one of those "kids, don't try this at home" matters. Consult a qualified tax advisor, because a mistake can be very expensive.