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.
An Independent Thinker
With all the benefits that come with hiring employees, why even bother with independent contractors? The answer is those same taxing reasons. Independent contractors are clearly cheaper from a tax perspective, says Kaplan. "You can get away with a check for services rendered and absolutely no filing requirements except for a year-end Form 1099." (More about 1099s later.)
The difficulty comes in making sure that person meets the IRS' definition of an independent contractor, and those guidelines are murky, according to Allan Kruger, a principal in accounting firm Kruger & Co., P.A. in Ft. Lauderdale, Florida.
There are 20 factors the IRS uses to determine whether someone is an employee or an independent contractor. (These factors are contained in IRS Publication 937, Employment Taxes and Information Returns, available by calling the Freedom of Information Reading Room at 202-622-5164.) Among the key factors the publication lists:
Who has control? "A worker is an employee if the person for whom he works has the right to direct and control him in the way he works, both as to the final results and as to the details of when, where and how the work is to be done. The employer need not actually exercise control; it is sufficient that he has the right to do so."
Right to fire. "An employee can be fired by an employer. An independent contractor cannot be fired so long as he or she produces a result that meets the specifications of the contract."
Training. "An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods and receive no training from the purchasers of their services."
In addition, says Kaplan, the IRS considers whether the person works full time and whether all the work has to be performed on the employer's premises--both signs of an employee-employer relationship.
Kruger cautions business owners against relying too heavily on any one specific factor. "There are so many different factors. In each circumstance it's difficult to determine what the IRS is going to say," he says. "Even if your person passes the 20-point test, the IRS may not view the results the same way you would."
In fact, adds Satuloff, these guidelines have been applied inconsistently in various IRS districts across the country.
You've Got the Wrong Man
Given that the IRS' system for classifying workers is imprecise at best, what happens if someone is misclassified? According to Satuloff, business owners, not independent contractors, face the greatest exposure. The important thing to remember is that whichever classification you use, you need to apply it consistently.
If the IRS decides you used the wrong classification--and this usually means a person you classified as an independent contractor is really an employee--for each person misclassified, your company is liable for back taxes plus any accrued interest and penalties. Worse yet, if the IRS determines your misclassification was "willful," you'll be assessed additional penalties-and you run the risk that the IRS will choose to go back to any open years and examine your tax returns to see if a pattern exists.
According to Kaplan, it's dangerous to treat someone as an independent contractor and not follow through by filing a Form 1099, which indicates payments to vendors. "This is the form that leads the IRS from the business back to the independent contractor to see if there's compliance," he says.
More bad news for business owners, says Jill Jachera, a partner at Klehr Harrison, is that there are other legal ramifications if you classify someone as independent and the IRS reclassifies him or her as an employee. For instance, certain laws go into effect based on the number of people you employ. The Family and Medical Leave Act kicks in when you have 50 employees, and the Americans With Disabilities Act applies when you have 15 employees. Complying with either of these can add additional expenses in the form of benefits and capital improvements.
Since the IRS generally prefers to assume everyone is an employee, it's harder to ensure a worker's status as an independent contractor. Satuloff suggests some things you can do to shore up someone's independent status:
1. Document the relationship with a contract. "This can be a simple agreement that spells out the duties of the independent contractor," he says. The agreement should also state that the independent contractor, not the employer, is responsible for withholding any necessary taxes.
2. Have the independent contractor submit invoices. "Time sheets and subsequent invoices go a long way in substantiating a contractual relationship," Satuloff says.
3. File a Form 1099 at year-end. By law, you are required to file and give someone a Form 1099 if you pay him or her more than $600 a year.
Classification issues are complicated, but don't let them get the best of you. Remember, tax considerations are just that; they should be a factor in your decision, not the sole reason you make it. When it comes to hiring, the most important consideration is getting the best person for the job.
Nancy L. Scarlato contributed to this article.