By Debora D. Peters
I have represented a number of clients being audited for federal employment tax issues. This type of audit is extremely intrusive and time consuming. The most common mistake I see employers make is misclassifying a worker as an independent contractor. An employer is required to withhold and pay employment taxes for an employee. An independent contractor is considered self-employed and therefore responsible for paying his or her own taxes. Many employers are tempted to classify a worker as an independent contractor to avoid state and federal employment taxes.
When hiring an individual to provide services, an employer must determine whether the individual is an employee or an independent contractor.
You must determine how to treat payments you make for services rendered to your business. We have to consider the business relationship that exists between you and the person performing the services. There are four primary types of employees: employees (common-law employees), independent contractors, statutory employees and statutory non-employees.
In this article, which includes verbiage directly from the Internal Revenue Service, we will only be addressing the two most common.
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered, according to the IRS.
Independent contractors are generally self-employed if any of the following apply:
– They carry on a trade or business as a sole proprietor or an independent contractor.
– They are a member of a partnership that carries on a trade or business.
– They are otherwise in business for themselves (including a part-time business).
For a common-law employee, facts that provide evidence of the degree of control and independence fall into three categories: Behavioral, financial and type of relationship.
– Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
– Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
– Type of relationship: Are there written contracts or employee benefits (pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that makes the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The consequences to misclassifying a worker are usually great enough that it creates a financial hardship upon the employer. In many instances, the tax, penalties and interest are so high the employer faces insolvency. As tempting as it may be to classify a worker as an independent contractor, when you are audited it will prove to be a grave mistake that you may not recover from. Remember, we all know that it is just a matter of time before you will be audited; make sure that you have audit-proofed your books and records as well as your workers. In next month’s issue, I will address estimated tax payments. No matter what type of entity you are, you will be required to make quarterly federal estimated tax payments.
Debora D. Peters, of Peters Tax Solutions LLP, is an accredited tax preparer who has represented hundreds of clients under federal and state audits. She obtained her Enrolled Agents License in 2009.