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It's Classified

Are they really contractors rather than employees? If you don't get it right, you could face steep penalties.

It's tempting to classify your hired help as independent contractors to avoid paying employee payroll taxes. But it's also very dangerous to incorrectly classify them--the IRS will hit you with hefty penalties, and you risk having to pay even more than you would have owed with payroll taxes. Bruce Mayberry, CEO of Capitol Tax Relief, a legal service in Woodland Hills, California, counsels small businesses and private citizens on such tax issues. According to Mayberry, the IRS doesn't play around with 941 violations, the tax code dealing with employer tax.

To prevent an IRS snafu in the first place, start-ups should be very clear about who qualifies as an independent contractor and who is an employee. The IRS even provides a form to clarify it for you: Fill out Form SS-8, Determination of Worker Status, to certify it once and for all. The IRS will send you a letter saying "yea or nay" that you can keep for your records. Sample questions to ask yourself: Do you and your independent contractor have a written contract? Does he work in his own office or shop? Does he work for several businesses at one time? If you answer "yes" to these questions, this person is likely an independent contractor.

If you do find yourself in trouble with the IRS, there is some hope. Mayberry notes that early action can save you time and money. "The big problem is the snowballing effect," he says. With penalties, an $18,000 bill can quickly become $50,000. Visit the IRS Web site and search the Forms and Publications section for Publication 15, which deals with employment taxes and who qualifies as an employee.

This story appears in the June 2003 issue of Entrepreneur. Subscribe »