This is the time of year we normally start talking about year-end tax planning, but we went back to last year's articles in the archives and believe they are still applicable this year. Although we will be discussing year-end issues over the next few months, we commend to you the October, November and December articles from 2003 for a more thorough discussion of year-end tax planning.
We thought we might talk a bit about business mythology this month, especially concerning employees. Here is the basic myth:
Employers decide whether a person is an employee or contract laborer. Besides, it doesn't really make much difference as long as the employee/contractor reports the income.
Just to show how flexible we can be, we'll start off with the second myth first. Does it really matter to the Internal Revenue Service if a worker is treated as an employee or as a contractor? Let's see, now...how do we put this politely and succinctly...YOU BET IT DOES! The effects of mistreating a worker's job classification can be devastating! This can best be illustrated by the following scenario:
- Income paid to employee, including expense reimbursement - $100,000
- Expense reimbursement - $10,000
- State taxes deductible - $4,200
- Contributions - $2,500
- Home mortgage interest - $10,000
Using the "employee scenario," the Internal Revenue Service/Social Security Administration will receive $13,688 between the employer and employee for Social Security/Medicare tax withholdings and $14,983 in income taxes from the employee for a total of $28,671. Under the "independent contractor scenario," the employer pays no taxes and the employee pays $25,496 between self-employment and income taxes. The difference of $3,175 is money you can bet the United States Treasury wants.
The effects of our example are mild compared to what happens to many taxpayers. Many times, the deductions an "independent contractor" claims are far more substantial and, on audit, if the contractor is really an employee, the results are devastating.
So how do you avoid the pitfalls of improperly classifying those who work for you? Aside from relying on prayer or pure luck, you could use a handy list of 20 factors the IRS uses in determining if a worker is an employee or independent contractor. Even with the list, the factors on which are discussed in the following paragraphs, you will still need to exercise judgment when classifying your workers. As you read these factors, bear in mind that the overriding issue is one of control; how much control you have over the actions of the worker.
Instructions - If your worker is required to comply with your instructions about when, where and how he or she is to work, they are ordinarily treated as an employee. Independent contractors normally are required only to produce a result, but control over how and where the work is to be done is up to the contractor. Within the limitations of a contract, the "when" the work is to be done is also up to the contractor.
Training - If you train new personnel by requiring them to work with experienced employees, require attendance at training meetings, corresponding with the worker or otherwise taking the training, and cost thereof, on yourself, your relationship is indicative of an employer-employee relationship.
Integration - Does your worker perform services that your business can't live without? A high degree of reliance on a worker for a businessÂ’ success, indicates that worker is more of an employee than an independent contractor.
Services rendered personally - If a worker must perform the services personally, the presumption is that the employer is interested in the work being performed in a particular manner; thus indicating an employer-employee relationship.
Hiring, supervising and paying assistants - If you, or your worker, hire, supervise and pay assistants, this indicates an employer-employee relationship. However, if a worker hires, supervises and pays assistants pursuant to a contract under which that person provides materials and labor, and the contract only calls for a specified result, then this indicates a contractor relationship.
Continuing relationship - A continuing relationship indicates an employer-employee relationship. For these purposes, "continuing relationship" means work is performed at frequently recurring although irregular hours.
Set hours - If you set the hours for the worker or require the worker to be on site at specific hours, this indicates an employer-employee relationship.
Full-time - If you require your worker to devote substantially all of his or her working efforts to your business, then he or she is likely an employee. Contractors are generally free to come and go as long as the result is achieved and they are also free to work for other customers or clients.
Working on employer's premises - Requiring the work to be performed on your premises suggests a worker is an employee.
Set order or sequence of work - If work must be completed in a particular order or sequence set by you as employer, this suggests sufficient control to classify the worker as an employee.
Oral or written reports - If you require the worker to provide oral or written reports, then this suggests a degree of control over the worker and may indicate employee status.
Payment by hour, week or month - Payment by the hour, week or month, except as a convenient way to break up the total cost of a contract, generally points to an employer-employee relationship. On the other hand, payment on straight commission or by the job tends to point to independent contractor status.
Payment of business or travel expenses - It's presumed that if you pay for your worker's travel and other business expenses, you have some degree of control over the worker's business activities. If, however, the worker provides labor and materials (including out-of-pocket expenses) under a contract that requires only a specific result be achieved, you have a stronger argument for the worker being an independent contractor.
Furnishing of tools and materials - If you provide the materials and tools necessary to complete a task, you are dangerously close to having an employee. Independent contractors generally provide their own significant items of equipment and generally the necessary material.
Investment - If a worker invests significantly in the facilities needed to complete a job, this generally points to an independent contractor. If you, rather than the worker, are required to make the investment, you are probably looking at an employee and not a contractor.
Who keeps the profit or pays for the loss - The incentive for employees to work hard and make money is a periodic paycheck. In general, you generally keep the profit, if any. Independent contractors, on the other hand, rely solely on the profit generated by a contract.
Working for more than one employer - We said earlier that a contractor generally has more than just one customer. Intuitively, the same person working for more than just one employer might indicate the worker is a contractor. This is not, however, always the case. You also have to look at other control aspects to determine whether the worker is an employee of the entities for which they work.
Services available to the general public - If a worker makes the services rendered to you available to the general public on a regular and consistent basis, this indicates that the worker is an independent contractor.
Right to fire - If you, as employer, have the right to discharge a worker without incurring any contractual penalty, that person is most likely an employee.
Right to quit - The converse of the right to fire is the right to quit. If a worker can quit without notice and incur no penalty, then that person is more of an employee than a contractor.
The IRS has developed a list to make things easier on employers in the employee classification game. If you are like most people, after you read that list, you find out things aren't as simple as they seem. For example, accountants and lawyers regularly charge clients for out-of-pocket expenditures. Does that make them employees? Our guess is no. On the other hand, many contracts require only a written notification of a contract termination and attach no penalty. Then again, if you do not require a worker to be at the office at a specified time, but just expect the work to be done, does that necessarily mean the worker is a contractor? Again, the answer is "not necessarily."
Each of these factors does not necessarily control the classification of a worker by itself, but if, after looking at the factors and concluding you pretty much control the business life of a worker, you probably have an employee. Classifying a worker is more of an art than an exact science, and you are in luck because we are artists. If you have a question on the subject of independent contractor versus employee, give your local artist...errrr...CPA a call. If you don't have one, we are available to help you paint the right employment picture for you and your workers.
Until we meet on November 1, have a super October and remember, your vote counts just as much as the next persons...make your vote count.