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Business Owners: Avoid the Independent Contractor Trap

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Business owners often prefer to use independent contractors for some tasks rather than employees. Advantages to using independent contractors…

  • More flexibility in personnel assignments, including the ability to assign projects to people with specific expertise when needed.

  • No outlays for payroll taxes, including Medicare, Social Security, unemployment, and withheld income taxes.

  • Lower employee benefits costs.

Trap: To the IRS, most workers are more properly classed as employees rather than independent contractors. Employees receive regular paychecks from which payroll taxes must be withheld. In contrast, the government must rely on independent contractors to pay taxes themselves — making payment much less reliable. As you might expect, the IRS prefers to see payroll taxes flow in regularly from employers.

Result: When companies use independent contractors, the IRS frequently will assert that those workers are really company employees. Your state’s taxing authority also may claim that independent contractors really are employees.

KEEP CONTROL

Of course, some workers actually are independent contractors, while others could reasonably be considered employees. Three factors…

  • Behavioral control. The more say you have in how a worker performs his/her duties, the more likely that worker is legally an employee.

    Generally, if you have the right to tell someone how to do his job, he likely will be considered an employee. On the other hand, if you’re mainly concerned with results rather than methods, you might legitimately say that you are dealing with an independent contractor. Example: A publisher tells a freelancer to write an article, rather than how to write it.

  • Financial control. An employee generally receives a regular salary and perhaps a bonus. Supplies and equipment are provided, and business-related outlays are reimbursed.

    The closer your financial arrangement is to this model, the more likely your worker is to be an employee.

    In contrast, an independent contractor may be paid irregular amounts at irregular intervals. He might have to make some personal financial investments in his business — meaning that he might realize a loss from the activity.

    The more the merrier: If a worker has multiple sources of significant income, you are more likely to be able to make the case that he is an independent contractor.

  • Duration of relationship. How long does an individual intend to work for your company? If someone intends to perform tasks indefinitely, the IRS might consider him an employee. That’s especially true if employees formerly performed such tasks for you. Example: Computer programmer.

    On the other hand, short-term engagements may be a sign that someone is an independent contractor.

    Trap: An officer of a corporation can’t avoid being classified as an employee.

CONTRACTS FOR CONTRACTORS

Any contracts you have with workers, and the terms of those contracts, may play a role in the employee-versus-contractor determination.

Strategy: Make sure that you have a written contract with each individual whom you would like to treat as an independent contractor. Draft the contracts to cover a specific time period or task and make the contract subject to potential renewal every year or with each new project. Have the contract specify that the worker…

  • Will not be treated as an employee for federal or state income tax purposes.

  • Will not receive a regular salary, but instead will be compensated directly related to services rendered.

  • Will be responsible for paying his own Social Security and Medicare taxes.

  • Won’t receive employee benefits.

  • Won’t be covered by workers’ compensation.

  • Won’t be under the control of the employer as to how a job is done.

DEALING WITH THE IRS

If you would like the IRS to decide the status of your workers (for example, because you’re confident of a positive decision), you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS for review.

Trap: In many cases, the IRS rules that a company submitting Form SS-8 has employees, not contractors.

Result: You might be better off just reading the form to see what concerns the IRS.

Example: “List the benefits available to the worker (e.g., paid vacations, sick pay, pensions, bonuses, paid holidays, personal days, insurance benefits).” Then you can structure your relationship with workers to boost the chance that it will conform to the IRS’s idea of independent contractor status.

NOW FOR THE GOOD NEWS

The Small Business Job Protection Act included a provision that the burden of proof in independent contractor cases is on the IRS, once the taxpayer establishes a prima facie (apparent) case for his classification of workers as contractors.

What it means: A tax professional can assert, in writing, that your company can treat certain workers as independent contractors. This will give you a reasonable basis for classifying the specified workers as independent contractors.

Strategy: Get this statement on record before the issue is raised by the IRS or your state’s tax collectors. Once you’ve established your prima facie case in this manner, it’s up to the government to prove that your contractors are really employees. That can be a difficult task and increases your chances of winning in court.

Loophole: If your company has been audited on the independent contractor issue, and no change is determined, you have a “prior audit safe haven” under Section 530. You’ll have a reasonable basis for treating workers as independent contractors unless the relationship between your company and its workers has changed materially since the no-change audit.

Bottom line: To build a solid case for classifying a group of workers as independent contractors, follow these guidelines…

  • Have all affected workers sign annual contracts stipulating that they are independent contractors rather than employees.

  • Issue Form 1099s for every independent contractor you paid $600 or more per year.

  • Work with a tax professional to help establish and maintain these conditions.

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Source:

Alan S. Zipp, Esq., CPA, 932 Hungerford Dr., Rockville, Maryland 20850. Mr. Zipp is an instructor of income tax courses for the American Institute of Certified Public Accountants. He specializes in the income tax problems of individuals and small businesses.

Date: July 1, 2008 Publication: Bottom Line Wealth
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