Individuals performing services for your business are usually tax code classified as either regular employees or independent contractors (meaning self-employed for tax purposes). A small percentage of people are in one of two other categories: statutory employees or statutory nonemployees. All of these distinctions are very important to the IRS, and it can be costly if you don’t pay attention to them. We talk about these classifications in this post.
Reporting Payments to Independent Contractors
Business owners have payroll tax withholding and reporting obligations for all of their employees. Employees’ earnings are reported to the IRS on quarterly Form 941s and annually on W-2 forms. On the other hand, with a true independent contractor, business owners don’t have to withhold or report payroll taxes. However, an independent contractor may choose to have tax withholding by a payor. There’s a box on the 1099 form that notes withholding.
Business owners’ only reporting duty to the IRS is to issue a Form 1099 once a year to each service provider. There are 11 versions of Form 1099; the 1099-MISC is the one you issue to independent contractors.
Who Else Should Get a Form 1099-Misc?
- Professionals –> Attorneys, accountants, and consultants.
- Landlords –> If you paid $600 or more for rent.
- Prizes, awards –>If you received $600 or more; winning contestants.
- Royalty payments –> Only $10 or more threshold.
- Consumer product sales –> If sold to a person for resale anywhere other than a permanent resale establishment.
Don’t report independent contractor payments to the IRS if:
- you pay a service provider less than $600 a year;
- the services were performed for you personally and not for your business;
- the independent contractor is incorporated; or
- the work was done by foreign nationals in their own country (outsourcing).
Using an independent contractor saves time and expense complying with IRS reporting requirements. It also saves money—owners don’t have to pay the employer’s share of the FICA contributions of 7.65% for each worker. You won’t have to pay unemployment compensation tax (FUTA ), either. But the IRS is very aware of the benefits of misclassifying an employee as an independent contractor, and has wide powers to make life miserable for all those it catches doing it.
Are business owners employees? Solos, LLC members, and partners are neither employees nor independent contractors. These owners don’t have to fool with payroll taxes. Instead, they mail quarterly estimated taxes to the IRS. However, working shareholders/owners of corporations—C or S corporations—are employees and subject to payroll tax rules.
Worker Classifications Warning
No other classifications of workers are recognized by the IRS. Many employers mistakenly believe that a short-term worker is not an employee. Maybe, but whether part-time or temporary, called a consultant or subcontractor, a worker must fit into one of the four categories discussed below.
Anyone performing services controlled by an employer [that is, what work will be done and how it will be done] is legally a common law employee, or just plain employee. Even if an employer doesn’t actually exercise control, but has the legal right to control the method and result of the work done, there’s an employer-employee relationship.
Here are more factors that tend to show the IRS a worker is a common law employee:
- The worker follows instructions about when, where, and how to work.
- The worker is trained by the employer to perform services in a particular manner.
- The worker’s services are integrated into the business operation, or a continuing relationship exists.
- The worker renders services personally (she can’t subcontract work out to someone else).
- Assistants are hired by the business, not the worker.
- The worker has set hours.
- The worker devotes substantial time to the employer.
- Work is done on business premises.
- The worker submits reports regularly.
- The worker is paid by the hour, week, or month, unless these are installments of a lump sum amount agreed to for the job.
- The business pays the worker’s business or travel expenses.
- The business furnishes tools, equipment, and materials.
- The business can fire the worker, and the worker has the right to quit, at will.
Folks in business for themselves and not subject to control by those who pay them are independent contractors, not employees. When you hire an independent contractor to accomplish a task for your business, you don’t have an employer-employee relationship and, therefore, don’t have to withhold and pay employment taxes.
Independent contractors are responsible for their own tax reporting and are treated as business owners themselves. The IRS says these factors tend to show a person is an independent contractor:
- The worker hires, supervises, and pays her own assistants.
- The worker is free to work when and for whom she wants.
- The work is done on the worker’s premises.
- The worker is paid by the job or on straight commission.
- The worker has the risk of profit or loss.
- The worker does work for several businesses at one time.
- The worker’s services are available to the general public.
- The worker can’t be terminated early, except for breach of contract.
See IRS Publication 15A, Employer’s Supplemental Tax Guide, for more help on distinguishing independent contractors from employees.
Next, let’s talk about satutory employees and non-employees a little bit. Read on…
Federal law automatically classifies some workers as statutory employees. [IRC-3121(d)(3)]. Statutory employees have taxes withheld by their employers.
This unusual tax category covers:
- corporate officers who provide services to the corporation;
- delivery drivers of food, laundry, and similar products, even if they are paid strictly on a
- full-time, business-to-business salespeople, paid on commission—such as manufacturer’s;
- representatives and other traveling salespeople who do not sell directly to the public;
- full-time life insurance agents working primarily for just one company; and
- home workers who do piecework according to a business’s specifications and are provided the materials.
Example: Martha is an on-the-road salesperson for LieDharma Co, a roofing materials manufacturer selling to building contractors. She works out of her car and an office at home, visiting the LieDharma Co headquarters only twice a month to pick up samples and commission checks. LieDharma Co has little control over how and where Martha does her work. Although her work meets some requirements of an independent contractor, Martha is a statutory employee.
Tax Form: Employers must issue W-2 forms to statutory employees; however, they can deduct their business expenses, like independent contractors. A statutory employee reports wages and expenses on Schedule C, the same form used by sole proprietors.
The fourth tax code category for working people is the statutory nonemployee, sometimes also called “an exempt employee” [IRC-3508]. Statutory non-employees are treated as independent contractors and are not subject to tax withholding. This classification covers only two types of salespeople:
- licensed real estate agents working on commission only; and
- direct (to the customer) sellers of consumer products—if the sales take place somewhere other than a retail store or showroom.
Statutory nonemployees report wages and expenses on Schedule C, the same as sole proprietors. A statutory nonemployee’s income must be directly related to sales—not to hours worked.
Example: Dr. Andrew Liem operates BeautyFace, a wholesale cosmetics business, and reports that his salespeople are statutory nonemployees. This will stand up to an IRS audit as long as all sales are made off Lorenzo’s premises, sales are to consumers of the cosmetics, and the salespeople are paid strictly on commission.
Misclassifying Employees as Independent Contractors [Be Ware!]
Small businesses often run up against IRS auditors by calling their workers independent contractors instead of employees. The interests of the business owners and the IRS are diametrically opposed: The IRS wants to collect employment taxes for as many workers as possible, and the business owner wants to avoid employment taxes. Indeed, a small business can save a bundle by not classifying workers as employees. According to the U.S. Chamber of C ommerce, it costs a business 20% to 40% more per worker to treat them as employees.
How Does the IRS Finds this Out? If your business is audited for any reason, the IRS looks at payments made to independent contractors. The Wall Street Journal reported that in one six-year period, the IRS performed more than 11,000 audits of companies using independent contractors. The results: 483,000 reclassifications of independent contractors to employee status and $751 million in back taxes and penalties!
Also, special IRS teams search for misclassified workers under the ETE [Employment Tax Examination] program. Typically, these ETE audits focus on industries where abuses are suspected. Recent targets include temporary employment agencies, nursing registries, and building contractors.
Enterprises can also be selected for filing many Form 1099s for independent contractors. The IR S is very selective in its enforcement of work classification rules. It picks on small businesses, while major corporations often flout the worker classification rules. Two of the largest employers in the San Francisco Bay Area frequently hire independent contractors. These Fortune 500 giants furnish offices, require regular work hours, and treat these so-called independent contractors like their regular employees—except they do not pay employment taxes or give the workers any benefits.
Caution!: State employment tax agencies can also penalize you. If a worker who was misclassified as an independent contractor is laid off and makes a claim for unemployment benefits, it triggers a state agency inquiry. If the state reclassifies a worker as an employee, the business owner will owe state payroll taxes plus penalties. The state may also turn the employer in to the IRS or vice versa.
Penalties for Misclassifying Workers
The IRS can order offenders to pay all employment taxes that should have been paid, plus a special penalty ranging from 12% to 35% of the tax bill.
Example: Jay, who wholesales American made bathing suits, faces stiff competition from cheap imports. To survive, he must keep prices low by cutting overhead to the bone. Jay decides to call his secretary, warehouse person, delivery person, and two inside salespersons independent contractors.
Here’s what he stands to save:
- Administrative work—filing quarterly tax-reporting forms, withholding employees’ pay, and making federal tax deposits.
- Social Security and Medicare taxes [With independent contractors the employer does not pay 7.65% of their wages as Social Security and Medicare taxes].
- Federal and state unemployment tax costs.
- Non-tax expenses, like workers’ compensation insurance, and employee benefits, such as sick leave and vacation pay.
The problem is that Jay’s workers are likely to be employees, not ICs!
Let’s continue with the next scenario…
The IRS audits Jay and reclassifies his secretary, Fannie, as an employee. Fannie was paid $20,000 per year for the past three years. Jay’s audit bill, with interest and penalties, could be as much as $30,000 if the auditor decides that Jay intentionally disregarded the law. If, however, the IRS auditor concludes jay made an innocent mistake, the tax bill would be about $15,000. Either way, it is a lot of money.
IRS Classification Settlement Program
The IRS offers an olive branch to small business owners found misclassifying employees. It’s called the “Classification Settlement Program [CSP]”. This is a relatively inexpensive way to come clean by making a CSP deal.
To qualify for the CSP, a business owner must have an open case with the IRS, either in an audit or in appeals, specifically request a CSP deal, and be in compliance with § 530 of the 1978 Revenue Act [known as the “Safe Harbor Rule“). That means an employer must have:
- filed all tax returns, including Form 1099s showing independent contractor payments
- treated all similarly situated workers as independent contractors
- had a reasonable basis for misclassification, such as reliance on court decisions, IRS
rulings, or written IRS advice; a past audit that resulted in no employment tax liability for workers in positions substantially similar to the workers in question; or a long-standing practice of a significant segment of your industry.
Qualifying employers will be offered one of three settlement deals:
- Past misclassifications won’t be assessed taxes.
- The most recent year of taxes for misclassifications must be paid and the IRS will forget about prior years.
- 25% of the latest audit year deficiency must be paid.
In addition, employers must agree to classify the workers as employees in the future. The IRS will monitor your business for five years to make sure you don’t fall back into your old ways. Which one of the three deals you get depends on the judgment of the auditor or appeals officer—and your ability to convince them you acted reasonably. Excuses that may work: reliance on the advice of an attorney or accountant; industry practice, even if not widespread; or your misinterpretation of the 20 factors used by the IRS to determine if a worker is an independent contractor.