Be careful in how you classify workers. Most people who work for you are likely to be employees and not independent contractors. But if you treat someone as an independent contractor and the Internal Revenue Service determines that he or she is really an employee, you may have to pay some big tax penalties.
The IRS much prefers that businesses treat workers as employees. Why? Because the IRS believes it will take in more tax revenue that way. The belief is that independent contractors often avoid paying income tax, as well as the self-employment tax that covers Social Security and Medicare. Employers can usually be counted on to withhold and remit all these taxes for their employees.
Getting tougher
It has always been necessary to classify workers correctly. But these days, for a number of reasons, the odds are higher that the IRS will check up on you. A respected tax resource, The Kiplinger Tax Letter, cites three developments:
• More states are aiding the IRS. Some 33 states are showing the IRS the results of their payroll tax audits.
• The IRS is using software to spot businesses that send Form 1099s to workers who have no other income. (Form 1099 is the annual income statement that an independent contractor receives; an employee, by contrast, receives Form W-2.) Based on its software matches, the IRS can look into whether the 1099 recipient should be re-classified as an employee.
• Workers who believe that a business misclassified them as independent contractor can now file a new form: Form 1819, Uncollected Social Security and Medicare Tax on Wages. Again, this alerts the IRS to take a closer look.
If you classify a worker as an employee and meet your payroll tax duties, you have nothing to worry about. You only have a problem if you make a mistake in classifying someone as an independent.
Making certain
So how do you avoid a mistake? By understanding the IRS approach. The IRS looks mainly at how much control you have over the worker. If you control or can control what is to be done and how it’s done, the worker is an employee. Here is an example:
Star Brite Drain Manufacturing hires Lou Ann as a consultant in the sales department. She is to ensure that the department is fully staffed and that sales brochures are stocked and available. She also is to review all sales contracts. However, Star Brite requires Lou Ann to get approval before she hires or fires anyone, purchases additional sales materials, or accepts any sales contract.
The IRS views the requirement of prior approval as evidence that Star Brite controls how Lou Ann gets her work done. If Star Brite simply lets Lou Ann exercise her own discretion, the company would have a good basis to treat her as a contractor.
Also, if a worker needs to buy or rent equipment to get the work done, that can help a company justify its position that the worker is an independent contractor. The worker’s investment in equipment must be significant, however. You also have a stronger position for calling someone a contractor if he or she:
• Works off your premises.
• Is paid by the job, not in regular amounts at stated intervals.
• Sets his or her own work hours.
• Works for other companies in addition to yours.
Getting advice
The IRS offers several online articles and publications dealing with worker classification. There’s a good overview in the article called “Employee or Independent Contractor?” Look for it on the IRS Web site at www.irs.gov.
The topic is also covered in IRS Publication 15-A, Employer’s Supplemental Tax Guide, also available online. If you’re unsure whether it’s safe to classify a given worker as an independent contractor, check with a lawyer or CPA. Or you can seek a determination from the IRS by using its Form SS-8.
To be on the safe side, you can ask the worker to form a one-person corporation, a fairly simple and low-cost process. The worker would be an employee of his or her own corporation. You’d pay the invoices sent to you by the worker’s corporation, and the corporation, in turn, would pay the worker.
In virtually all cases, the IRS will accept this type of arrangement and will not re-classify the worker as your employee. But heed this warning: Don’t help the worker set up the corporation or pay for incorporation costs. If you do, the IRS may treat the arrangement as a sham and hold you responsible for payroll taxes.
