Tax problems can arise when the IRS audits the company and decides to reclassify an independent contractor as a W-2 employee. For independent contractors, client companies submit a Form 1099-misc to the IRS reporting gross wages only. It does not report payroll taxes or withholding taxes. It is the individual contractor's responsibility to report taxes. Companies may save money on taxes with independent contractors, but, according to The Contract Employee's Handbook , reclassification of the contractor to a W-2 tax form is expensive for the client.
Some workers are clearly independent contractors, and others are clearly regular employees.
In the eyes of the IRS, however, there is no definite line dividing the two. According to The Contract Employee's Handbook , companies should avoid treating independent contractors like employees, if they wish to avoid an IRS audit. Companies must treat their independent contractors like the outside vendors that they are, and do whatever they can to avoid the appearance that any independent contractor is really their own employee. According to Top Echelon, an employer of record for contract employees, the IRS loses large amounts of potential tax money due to workers being misclassified as 1099 independent contractors. Understandably, the IRS has made it a priority to investigate 1099-misc forms that are turned in at the end of the tax year.