President Obama signed a new directive on January 20, 2010, that will increase IRS scrutiny of federal contractor’s tax obligations. It directs the IRS, along with Federal Contract Compliance Officers, to take steps to bar companies from receiving new government contracts if they are not tax compliant. Furthermore, the directive orders the IRS to review contractor filings to make sure companies are accurate in their reports about the taxes they have paid.

President Obama justified the directive on the basis of responsibility on the part of the federal government to collect taxes. The tax concern stemmed from the Government Accountability Office’s (“GAO”) investigations over the last three years. In the GAO’s July 2008 report, GAO found that over 1.6 million businesses owed over $58 billion in unpaid payroll taxes, including interest and penalties.

Part of the $58 billion in unpaid payroll taxes may include penalties for employers who have misclassified independent contractors. If the IRS or the Office of Federal Contract Compliance finds a misclassification, the contractor’s federal contracts could possibly be put in jeopardy because that may be considered a tax debt. The directive does not specifically mention misclassification penalties, but those are considered tax debts. Contractors will have to pay close attention to any new details that come out of the President’s order in the coming weeks and months as enforcement begins.

The President’s directive comes at a time when misclassification of independent contractor status is already garnering significant legislative and regulatory attention, especially given the nationwide budget and tax shortfalls at every level of government. While the issue of misclassification of independent contractors is not specifically targeted in this directive, it may nonetheless raise the stakes for federal contractors who use independent contractors.

As the issue continues to gather momentum, it is important for federal contractors to be extremely conservative in classifying independent contractors. The IRS has coordinated their efforts with the Department of Labor, the National Association of State Workforce Agencies, the Federation of Tax Advisors, and agencies that administer state employment and unemployment taxes. Currently, the IRS uses a three-factor test for determining whether someone is an employee or an independent contractor. The factors focus on behavioral control, financial control, and relationship of the parties. Contractors should be careful not to exercise too much control over independent contractors and stay informed of any changes to the regulatory standards.

Furthermore, it is important that employers understand the risk of misclassification. Since the mid-1980s, the IRS has reclassified 439,000 independent contractors and has collected $678 million in fines and retroactive payroll, social security and unemployment taxes. Along with the payments of back taxes and potential interest are heavy penalties, personal liability on corporate owners and possible criminal sanctions. And now contractors also face the possibility of losing their government contracts based on such tax debts.

If you have any questions or concerns about independent contractor classification or the IRS directive, please contact one of the authors of this alert, or your attorney.