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Declaration of Independents

When are employees not employees? When they're independent contractors.

With so many people working at home, telecommuting on the rise and entrepreneurial businesses abounding, you'd think the IRS would keep pace with the trend toward self-employment and homebased businesses, and adjust the tax code to fit the demographics of the country. You'd think so--but you'd be way off base.

For instance, what if it's time to bring someone else on board? Do you hire a full-time employee, or can you get by with an independent contractor?

Deciding how to classify someone who works for you is an issue that can have far-reaching implications, and Uncle Sam is looking closely over your shoulder to see to it you don't make the wrong choice. But small-business owners have experienced so much frustration untangling this problem that the delegates to the White House Conference on Small Business last June voted it the number-one issue requiring immediate reform.

In general, says Barth Satuloff, a CPA in Miami, anyone who performs a service for you and receives money for that service has to be classified as either an employee or an independent contractor. This classification is of particular interest to the IRS because it's their feeling that employees are generally more compliant in reporting their income than self-employed people. While this may seem patently unfair, the number of self-employed people "doing a little something on the side" who don't report the income from these jobs is high.

So if you need more than your own two hands to get the job done, who do you choose? Well, on the one hand, "There's no denying that employees are far more expensive [than independent contractors]," says Satuloff. For example, on top of the employee's salary, the employer has to withhold federal and, in some cases, state income taxes; Social Security; and Medicare--not to mention any company-provided medical insurance, pension or profit-sharing benefits, workers' compensation insurance, and any other benefits you may offer your employees. All this, says Satuloff, can add 10 percent to 30 percent to an employee's salary.

On the other hand, Satuloff cautions business owners not to overlook the advantages of hiring employees. A trusted employee can be an invaluable asset to a company, and investing in training, salary and benefits for someone who's going to stay with you for a number of years is often worth the higher cost. "You can't get as much allegiance from a contractual relationship," says Satuloff, adding that in most cases, "the long-term benefits of having a dedicated employee are far more advantageous than the short-term tax benefits of using an independent contractor."

Besides allegiance, there's another major reason employees make sense: The IRS likes them. According to Keith W. Kaplan, a tax lawyer with Klehr, Harrison, Harvey, Branzburg & Ellers in Philadelphia, it's easier for the IRS to keep track of an employee than to keep track of an independent contractor. Matching employees with employers through W-2 forms filed by their companies, for instance, is a piece of cake. Compare this with the hassle of shuffling through individual returns to determine if there is any unreported income, and you can see why independent contractors are a critical issue for the IRS.

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This article was originally published in the February 1996 print edition of Entrepreneur with the headline: Declaration of Independents.

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