If you are a business owner, whether you hire people as independent contractors or as employees will impact the amount of taxes you withhold from their paychecks, as well as how much and what types of taxes you pay. Furthermore, it will affect how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.
The obvious advantage to treating an individual as an independent contractor is avoiding the added expense of payroll taxes, employee benefits and worker’s comp insurance. Unfortunately, the decision is not optional, and employers must be careful when making the decision, lest they set themselves up for a payroll audit and back taxes, penalties, and interest.
Independent contractors are becoming a new focus of the IRS, and audits in this area are expected to rise sharply in the next few months. The IRS and the Department of Labor have agreed to share information and collaborate on the issue of employees who have been misclassified as independent contractors. An IRS study on the subject found that 15% of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $2.7 billion in inflation-adjusted 2006 dollars. The IRS already has in place a nationwide questionable employment tax practices (QETP) program. One of its goals is to increase voluntary compliance with employment tax rules and regulations.
Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.
Employers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. A worker may also file Form SS-8 requesting an IRS determination. IRS does not issue determinations for proposed or hypothetical situations.
Under the “common law” rules developed by the courts, a worker generally is an employee for federal tax purposes if the employer has the right to control and direct the worker regarding the job he is to do and how he is to do it. The employer doesn’t actually have to direct or control how the services are performed; it’s enough if the employer has the right to do so. IRS usually applies the following “20 factor test” to see if the employer has the right to direct and control the worker:
1. Instructions to the worker
3. Integration into business operations
4. Requirement that services be rendered personally
5. Hiring, supervising, and paying assistants
6. Continuity of the relationship (permanency)
7. Setting the hours of work
8. Requirement of full-time work
9. Working on employer premises
10. Setting the order or sequence of work
11. Requiring oral or written reports
12. Paying worker by the hour, week, or month
13. Payment of worker’s business and/or traveling expenses
14. Furnishing worker’s tools and materials
15. Significant investment by worker
16. Realization of profit or loss by worker
17. Working for more than one business at a time
18. Availability of worker’s services to the general public
19. Firms’ right to discharge worker
20. Worker’s right to terminate relationship
There is no litmus test for exactly how many of these factors must be satisfied, nor are these factors uniformly applied. Each case is decided based on the facts and circumstances of that case.
However, certain licensed professionals such as real estate salespersons and attorneys are not considered employees.
The Internal Revenue Service has launched a new program that will enable many employers to resolve past worker classification issues and to achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers. This new program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.
To be eligible, an applicant must:
• Consistently have treated the workers in the past as nonemployees
• Have filed all required Forms 1099 for the workers for the previous three years, and
• Not currently be under audit by the IRS, the Department of Labor, or a state agency concerning the classification of these workers.
Interested employers can apply for the Voluntary Classification Settlement Program at least 60 days before they want to begin treating the workers as employees. Employers accepted into the program will pay an amount effectively equaling just over 1% of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations rather than the usual three years that generally applies to payroll taxes.
The State of California has recently signed into law Senate Bill No. 459 which allows the State to charge a penalty of up to $25,000 per violation of knowingly misclassifying a worker.
Furthermore, IRS and California have an information sharing agreement. Thus, if you get audited by IRS and IRS determines that you had misclassified your independent contractors, they should have been classified as employees, they will notify the Employment Development Department (EDD) and EDD will audit you as well. It works the other way as well. If you get audited by EDD, which is usually the case because of an independent contractor who was let go and he or she applies for unemployment compensation, EDD will notify the IRS.
If you pay anyone as an independent contractor, you should really make sure that the classification is correct. Otherwise, it can be very costly!
The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.
David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at [email protected] or visit www.saacpa.com or www.SilkRoadRealtyInc.com.