Don't get caught by the IRS for improperly classifying workers. The IRS scrutinizes this information, trying to find entrepreneurs who may misclassify workers as independent contractors instead of employees. "It's an important issue for the IRS because worker misclassification may give a competitive advantage to the business using independent contractors," says Don Segal, the acting employment tax policy program manager for the IRS.
It's easier for the IRS to collect taxes from business owners than from independent contractors. Employers must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes on wages paid to employees.
Independent contractors generally have no withholding on their earnings and may not be able to pay their tax liability at the end of the year. "They end up as a collection problem [for the IRS]," says Segal.
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Anyone who performs services for you where you control what will be done and how it will be done is considered an employee by the IRS. With an independent contractor, the business has the right to control or direct only the result of the work done by the contractor, not the means and methods of accomplishing the result.
The IRS reviews business filings to determine if workers who were employees are converted to independent contractors in the same job category, says Segal. If they are, the employer has liability for both the employer and the employee portions of employment taxes. In addition, the employee must file a claim to get a portion of the self-employment tax refunded for past returns filed as an independent contractor.
If you use independent contractors, be sure to maintain completed W-9 forms, contractors' business licenses and certificates of insurance. You should have invoices, business cards, telephone listings and other documentation showing that the contractors operate businesses.
In addition, complete and file Form 1099-MISC, which is used to report payments made in the course of a trade or business to another person or business that is not an employee. Give the contractor a copy, and send one to the IRS if the contractor is paid $600 or more in the calendar year. There is a $50 per-form penalty for failing to file the form.
For more, check out two useful publications from www.irs.gov: Publication 15-A, Employer's Supplemental Tax Guide (see Chapter 2, "Employee or Independent Contractor?"); and Publication 1779, Independent Contractor or Employee.
Great Falls, Virginia, writer Joan Szabo has reported on tax issues for 18 years.
Originally published in the February 2005 issue of Entrepreneur Magazine