On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
If you are a small business owner, whether you hire people as independent contractors or as employees will impact the amount of taxes you withhold from their paychecks, as well as how much and what types of taxes you pay. Furthermore, it will affect how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.
The obvious advantage to treating an individual as an independent contractor is avoiding the added expense of payroll taxes and employee benefits. Unfortunately, the decision is not an optional one and employers must be careful when making the decision, lest they set themselves up for a payroll audit and back taxes, penalties and interest.
The IRS is auditing companies focusing their efforts on businesses failing to pay taxes on fringe benefits and misclassifying workers as independent contractors instead of W-2 employees.
Here are some things every business owner should know about hiring people as independent contractors versus hiring them as employees.
1. Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.
2. Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
3. Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
4. The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.
5. If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
6. If you can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your workers are probably independent contractors.
7. Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.
8. Workers can avoid higher tax bills and lost benefits if they know their proper status.
9. Employers can request the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. A worker may also file Form SS-8 requesting an IRS determination. IRS does not issue determinations for proposed or hypothetical situations.
The 20-Factor Control Test- Congress views the independent contractor as a source of tax gap funding and may, in the near future, alter the definition of an independent contractor and impose mandatory withholding. However, currently, a worker’s status as an employee or independent depends on the amount of control the employer has over the worker. The IRS has developed 20 factors to help determine the extent of this control. The importance of each factor varies depending on the kind of work being done. Lack of control isn’t necessarily shown if an employer allows a worker freedom of action. The 20 factors are:
(1) Instructions: A worker who must comply with instructions about when, where and how to work is considered an employee. An employer has control in this area if he/she has the right to require compliance with instructions.
(2) Training: Independent contractors ordinarily use their own methods and receive no training from their customers about how to do the job. On the other hand, training given the worker by the employer usually shows employee status.
(3) Integration: Employee status is often shown when a worker’s services are integrated into the business’ operations and the success of the business depends on the performance of those services. This factor may be one that works against supporting independent contractor status in nearly every situation–it’s very difficult to establish whether or not success of a business would depend on the worker’s contribution to an overall effort.
(4) Services rendered personally: A business which requires the worker to personally perform the services shows that the business is interested in the methods used to accomplish the tasks. This, then, shows control by the employer.
(5) Hiring assistants: If a worker hires, pays and supervises assistants to complete a contract that requires the worker to supply materials and labor and be responsible for the result, then the worker is independent. When the employer hires, supervises and pays assistants to help the worker, employee status is indicated for the worker.
(6) Continuing relationship: An employer-employee relationship is indicated if there is an on-going relationship between the employer and worker. This kind of relationship often exists where work is performed at frequently recurring (although irregular) intervals.
(7) Set hours of work: While employees normally have set hours of work, independents set their own hours.
(8) Full-time work: Independents work when and for whom they choose, while employees must work full-time for a business, with restrictions on the worker being able to work elsewhere.
(9) Work done on the premises: Work required to be done on the employer’s premises often indicates control, especially if the work could be done elsewhere. However, control may even be present when a worker performs services in his/her own offices. To pinpoint the importance of this factor, look at the nature of the services being performed. Control over the place of work may be indicated when the business has the right to compel the worker to travel a certain route or work at specific places. The worker should be required to work from his/her own office.
(10) Order of sequence set: When the employer sets the order of an employee’s duties, it shows control by the employer.
(11) Reports: If a worker must submit reports (oral or written) to the employer to account for his/her actions, control is also shown.
(12) Payments: Employee status is shown if a worker is paid by the hour, week, etc. The worker should not be guaranteed a minimum salary nor be offered any fringe benefits. If a drawing account is set up for the worker, the worker should be required to repay any excess drawn from the account over commissions earned. In effect, the job should be paid on a straight-commission basis.
(13) Payments of expenses: If the employer pays business or travel expenses of the worker, the worker is likely to be classed as an employee.
(14) Tools and materials: An employer furnishing all the tools and materials to do the job usually shows that an employer-employee relationship is operative.
(15) Significant investment: An independent has significant investment in facilities or equipment used to perform services for someone else.
(16) Profit or loss: An independent contractor can realize a profit or loss as a result of services performed. For example, a worker who has invested in expensive equipment to do a job runs the risk of incurring a heavy loss from the job. This indicates that the worker is an independent contractor. However, the risk that a worker will not be paid is not sufficient risk to categorically show independent status.
(17) Working for more than one business at a time: When a worker performs services for multiple firms at the same time, independent status is indicated.
(18) Offers service to the general public: When a worker who regularly and consistently makes his/her services available to the general public, he/she is an independent contractor.
(19) Right to fire: Whereas an independent can’t be fired as long as he/she produces a result that meets the specifications of the contract, an employee can be fired.
(20) Right to quit: The reverse of (19) is true here: an employee can quit a job at any time without incurring liability. However, an independent is responsible to meet the terms of a contract.
It is wiser to properly classify workers to begin with rather than find out later they have been misclassified and find yourself facing back payroll taxes and penalties. Please call this office if you have questions or need assistance in classifying your workers.
Voluntary Worker Classification Settlement Program – The Internal Revenue Service has a program that will enable many employers to resolve past worker classification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers. This program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.
To be eligible, an applicant must:
- Consistently have treated the workers in the past as nonemployees,
- Have filed all required Forms 1099 for the workers for the previous three years, and
- Not currently be under an employment tax audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.
Interested employers can apply for the program by filing Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees.
Employers accepted into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years.
If you feel you have misclassified workers in the past and would like to consider the IRS voluntary reclassification program, please call this office for assistance in applying or with any questions you might have.