Employee or Contractor?
You (Don’t) Make the Call – IRS Does
Editor’s Note: Several appraisers in California recently reported that the Employment Development Department (tax collectors) in their area is targeting appraisal offices looking for independent contractors where, in their judgment, “employees” should be. And theirs is the only opinion that counts. The consequences are back taxes owed that can easily bankrupt a small business. Consider yourself warned.
The letter you just opened details the results of the IRS audit of your business. You owe $35,423 in back taxes and over $12,000 in penalties. You have 10 days to pay. Why? The IRS has determined that the “independent contractors” you’ve hired over the last few years are actually employees. You should have been withholding taxes and paying the government. But don’t worry you have 10 days to take care of your error. Happy New Year.
If you need to review your situation, here are just a few of the IRS guidelines. For more, check with your accountant or visit: http://www.irs.gov/businesses/small/article/0,,id=99921,00.html.
From the IRS: 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. It is critical that you, the employer, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Who is an Independent Contractor?
A general rule is that you, the payer, have the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Example: Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, that she obtained through advertisements. Vera is an independent contractor.
How should I report payments made to independent contractors?
You may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, you must file Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees (e.g. independent contractors) for services performed for your trade or business.
Who is an Employee?
A general rule is that anyone who performs services for you is your employee if you can control what will be done and how it will be done.
Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week, and is on duty in Bob’s showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager’s approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.
Here are a few questions the IRS has developed to test employee vs. subcontractor status.
- Does the business require the worker to follow their instructions on how work is performed? If yes, this indicates employee status. An independent contractor will generally decide how the project should be completed and use their own process.
- Does the business provide training to the worker? If you’re hiring a person for a job they are not trained for and providing them with the training, that person is probably an employee.
- Does the business provide the workspace? Contractors who work off-site are more likely to be classified as independent contractors.
- Does the business determine the order or sequence in which work is completed? This indicates employee status.
- Does the business pay expenses? This is an indication that the business is directing the Independent contractor’s business activities.
- Does the business provide tools and equipment for the worker? Independent contractors would normally provide their own tools and equipment.
- Does the worker have profits and losses independent of the business? This is an indication that the contractor is running his own business and is an independent contractor. Working with multiple clients also generally indicates independent contractor status.
- Does the worker market their services to the general public? Employees do not generally market their services to the general public.
In short, the higher degree of control the employer has over the worker, the more likely the IRS will classify the worker as an employee. Your accountant can provide further guidelines for covering yourself in the event you decide your assistant is an independent contractor, such as: Putting your agreement with the independent contractor in writing; getting a completed I-9 form in order to issue a 1099 at the end of the year; saving any proposals/marketing materials from the contractor; paying invoices submitted to you by the contractor; not paying on an hourly basis.