LEGAL: IRS Examines Unemployed "Consultants"

Layoffs stemming from the economic downturn have, among other things, transformed happily employed mid- and upper-level technicians and managers into struggling entrepreneurs who call themselves consultants.

Meanwhile, officials at the Internal Revenue Service (IRS), Washington, D.C., are taking an extra hard look at this trend.

Using a guidebook specially tailored to the so-called “consultant” business, IRS auditors are learning how to spot hidden earnings and unjustified deductions. The tax agency's new manual is a product of the Market Segment Specialization Program, which began approximately 10 years ago. The program focuses on businesses and occupations that tend to offer more opportunities for fabrication, exaggeration and other misrepresentation in reporting income and expenses.

Not only are more consultants and other independent contractors entering the workforce, but also an increasing number of companies are outsourcing their work. Indeed, what the IRS sees are businesses that lay off employees who, within a week or so, are rehired as consultants. It's a financial compromise: the employer receives substantially the same services but saves payroll taxes and the cost of benefits; the employee, as an alternative to outright unemployment, takes on self-employment taxes and, among other incidentals, health insurance premiums.

A consultant who is a bona fide independent contractor may have little or no worry about IRS scrutiny. However, if the consultant too closely resembles an employee, both the consultant and the “employer” may encounter serious tax problems.

A legitimately self-employed consultant may report income and expenses on Schedule C of Form 1040. He must file estimated payments of federal taxes (Form 1040-ES) in four installments throughout the year. The consultant may deduct all unreimbursed business expenses that are reasonable, including travel and some of the cost of meals and entertainment.

By comparison, a company must withhold income tax from wages it pays to its employees and pay the employer's share of Social Security and Medicare taxes. The employer must send the withholding and payments to IRS on a semi-weekly or monthly basis. An employee may deduct unreimbursed business expenses only if, for the year 2001, they exceed two percent of adjusted gross income.

Incidentally, two issues that draw considerable attention from IRS auditors are whether the purported independent contractor is engaged in business to make a profit or simply carrying on a hobby. Also, a flag is raised when business and personal travel expenses are combined and each is not carefully segregated.

For further information, see IRS Publication 1779, which is available at