By Albert B. Crenshaw

Thanks to layoffs, the growth of entrepreneurship and other socioeconomic developments, pleasant and unpleasant, the number of people hanging out shingles as consultants is going up sharply.

The Internal Revenue Service has noticed.

The tax agency recently issued to auditors a guidebook on how to audit consultants. The guide is part of the agency's Market Segment Specialization Program, which it began in the early 1990s to better inform auditors of where different types of businesses might hide income or pad deductions.

The IRS is working through all sorts of businesses, but the agency and private analysts agree this is an opportune time to start looking at consultants.

"It's a very important issue now. There are more consultants because of the economy, and in the D.C. area we know that several large companies are going in for quite a bit of outsourcing," said Krish R. Krishnan, chief executive of NetCompliance Inc., a District-based provider of regulatory compliance advice.

The IRS is concerned that companies are laying off workers and then hiring them back -- some with only a minimal break in company service -- as consultants. That pushes the workers off the payroll, allowing the company to cut benefit costs and shift payroll taxes onto the worker.

This can be legal if the consultant truly is an independent contractor, but if he or she is an employee in disguise, there are tax consequences for the company and the consultant.

Employers are supposed to withhold income tax from employees and to pay their share of Social Security and Medicare taxes, among other things. Employees must report unreimbursed business expenses on Schedule A and they are deductible only to the extent that they exceed 2 percent of adjusted gross income. There are also limitations imposed on high-income taxpayers.

Contractors report expenses on Schedule C and are subject to fewer limitations.

Other key issues identified by the IRS are travel, meals and entertainment, and whether the consultant is really in business to make a profit or if it is a disguised hobby.

Auditors will check, for example, to see if the consultant mixes business and personal travel -- the former deductible, the latter not. They also will look to see if the taxpayer takes his or her spouse along, especially on trips abroad.

NetCompliance has posted the IRS guide on its Web site (

Members of Congress have hounded the Pentagon for years to crack open its piggy bank for small business. Everybody agrees, at least publicly, that making it easier for small companies to sell goods and services to the military is a good idea, stimulating innovation, spreading the wealth, etc.

But it never seems to happen.

"The Department of Defense may talk about more ways to give small businesses opportunities, but their actions speak much louder," Rep. Nydia M. Velazquez (D-N.Y.) said at a recent House Small Business Committee hearing on Pentagon purchasing.

The Pentagon accounts for about 65 percent of all federal procurement spending so the issue has real meaning. Last year, small businesses got $ 48 billion of "identifiable" procurement spending, but that was $ 2 billion short of its small business goal and $ 4 billion short of the goal for women-owned businesses, Velazquez said.

Critics point to "bundling" of contracts, by which several smaller contracts are bundled together into one big one. That benefits large contractors while leaving small ones unable to compete.

The Pentagon argues the practice can be more efficient in certain circumstances, but it agreed it has to do better and promised to try.

Despite the tax cut and the slowing economy, the federal budget surplus continues to attract interests that would like a piece of it. Just a little bite, they say. It's really for the good of the country.

Small business has lots of suggestions.

A group called the Alliance for Small Business Investment in Technology, for example, would like to change the rules for expensing and depreciating computers and other high-tech equipment.

Current rules require that computers and software be treated as having a five-year life for tax purposes, but businesses find that such equipment becomes obsolete long before then.

The group would like the "useful life" shortened, allowing for an accelerated write-off, and it wants the ceiling lifted on how much of such equipment can be written off in one year.

Sen. Christopher S. Bond (R-Mo.) agrees and is pushing a bill that would shorten the useful life of computers and software to two years and raise the ceiling on expensing equipment from $ 24,000 to $ 50,000.

The new chairman of the Senate Small Business Committee, John F. Kerry (D-Mass.), was behind the move last week to change the panel's name. The idea of the new name, Committee on Small Business and Entrepreneurship, is to send the message that not only does the committee act on issues important to small businesses generally, but that it is also concerned about the segment of the small business world that consists of high-growth businesses with high-wage jobs, a Kerry spokesman said.

Albert B. Crenshaw writes about small business tax and legislative issues every other Monday in Washington Business.