The IRS on Employees Versus Independent Contractors
It is an age-old conundrum: determining whether a worker is an employee or an independent contractor. While it might seem like a simple question, it is not. And the IRS is hot on the heels of any contractor who does not understand the difference.
For example, in the traditional employer-employee relationship, the employer is responsible for a number of tasks, such as withholding federal and state income taxes, paying unemployment taxes (FUTA), withholding the employee’s share of FICA and Medicare taxes, remitting the amounts withheld, and paying both the employee and employer portions of FICA and Medicare taxes.
Independent contractors are responsible for their own taxes. In addition to making estimated tax payments for their federal and state income tax liabilities, they are subject to self-employment tax, which covers both the employer and employee shares of FICA. (They are, however, entitled to a deduction for the “employer’s” portion.)
Why the IRS Prefers Employee Status
The IRS has a strong preference for employee status because it is easier and cheaper to collect taxes from a single employer than from multiple independent contractors. If the IRS reclassifies independent contractors as employees, it can go after your company for back taxes that should have been paid, payroll and income taxes that should have been withheld, plus penalties and interest.
Additional penalties may apply if the IRS finds that you intentionally disregarded your tax obligations. And, of course, your state may impose penalties of its own. Finally, “responsible persons,” including certain officers, partners and managers, could be personally liable for uncollected taxes.
Even if workers you treat as independent contractors have paid their taxes, you are not necessarily safe. If the IRS finds they should have been classified as employees, it still may hit you with penalties equal to 20% of your tax liability.
Avoiding the Consequences
The simplest way to avoid these consequences is to treat workers as employees unless they clearly qualify as independent contractors. The IRS typically examines and weighs numerous factors to determine whether a worker is an employee or independent contractor. These considerations indicate to the agency the degree of control exercised by the employer and the degree of independence of the worker.
For instance, the IRS looks at behavioral control such as instruction (employees usually receive detailed instructions about when, where and how to work) and training (employees often receive training on how to perform their job duties).
Other Indicators Can Help Determine the Relationship
The type of relationship is also important. Does the individual receive benefits? Is he or she working for the business indefinitely? Are his or her services critical to the company’s ongoing operations? Affirmative answers to any or all of these questions would bolster an IRS case that the person in question is an employee, not an independent contractor.
Another important issue is financial control. The IRS will look for unreimbursed business expenses, which are usually incurred by independent contractors, not employees. Independent contractors often make significant investments in facilities and equipment as well; employees do not.
In addition, employees are usually paid by the hour, week or some other period. But independent contractors generally receive a flat fee or submit an invoice for services. So method of payment is a key consideration. Independent contractors will also often continue marketing themselves while working on a given project and risk suffering a profit loss on every job.
Ultimately, no one factor controls the outcome. You need to examine and weigh all the factors to determine whether a particular worker is an employee or independent contractor.
Stay on the Right Side of the IRS
If you are uncertain about the status of your workers, contact your tax advisor. In the event that contractors are misclassified, your tax pro can advise you whether the IRS Voluntary Classification Settlement Program is a good option for you. For help determining which workers are truly employees and which are independent contractors contact Rob Swenson at [email protected] or call him at 312.670.7444.
This issue’s tips focus on why it is critical to watch out for tax scams; the alternative simplified credit (ASC) method as an easier way to claim a research credit and proposed mandatory accrual accounting for some personal service firms.
Watch Out for Tax Scams
It is important to continuously be on the alert for tax fraud. Every year, the IRS publishes its list of “Dirty Dozen” tax scams. Here are two of the most common:
An identity thief uses your identity to file an illegal tax return and claim a refund. To avoid this scam, always file your return as early as possible. If you receive any suspicious tax-related notices or any of your personal information is lost or stolen, contact the IRS right away to secure your tax account.
A caller pretending to be with the IRS claims you owe money and threatens you with loss of your driver’s license or even arrest if you do not pay. Remember, the IRS always initiates contact by mail, not by phone, so if a claimed tax liability is news to you, it is probably not legitimate. If you are uncertain whether you owe taxes, call the IRS at 800.829.1040. And if you are certain that you do not, call the Treasury Inspector General for Tax Administration at 800.366.4484 to report the incident.
Have You Researched the Research Credit?
Claiming traditional research credits requires a company to compile and analyze years of historical data, a process that can be time-consuming and expensive. The alternative simplified credit (ASC) is easier to calculate and document, but until recently, it could only be claimed on a timely filed, original tax return (including extensions).
In June 2014, the IRS issued new regulations that allow companies, with certain exceptions, to claim research credits for open tax years using the ASC method on an amended return. If you missed the opportunity to claim the ASC in prior years, consult with your tax advisor to see if you are eligible.
Mandatory Accrual Accounting for Personal Service Firms?
Under current law, personal service businesses — such as law, accounting, architecture, engineering and consulting firms — are allowed to use the cash method of accounting for tax purposes, regardless of size (unless they have inventory). But this may change if certain lawmakers have their way. Potential legislation in Congress would require these companies to use the accrual method if their annual gross receipts exceed $10 million (using a three-year average gross receipts test).
Plenty of opposition stands in the way, but if this proposal becomes law, many personal service firms will find themselves with accelerated tax liabilities for receivables that have not yet been collected. Firms should have a plan for financing these liabilities in the event they are required to switch from the cash method to the accrual method.
For questions about these tips, contact Rob Swenson at [email protected] or call him at 312.670.7444.