In recent years, the IRS has taken a closer look at the relationship between small businesses and the individuals providing services for them. The agency is scrutinizing whether the individuals proving labor should be classified as employees or independent contractors.
The focal point here is that the IRS wants to establish whether the employer failed to withhold and/or remit withholdings for income taxes, Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In general, you don’t have to withhold or pay taxes on payments to independent contractors.
In my practice, I personally have helped many small business owners negotiate payroll tax/IRS disputes. In many of these cases, the tax issues arose because the employers were unaware of the distinction between the two hiring statuses. Consequently, their companies were hit with expensive tax bills. In some cases, the tax issue escalated with the IRS assessing trust fund recovery penalties. When this occurs, a business owner’s personal assets can be in jeopardy.
According to the IRS, they will look at the following criteria to make a determination:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
It can be confusing, since some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no set number of factors that makes the worker an employee vs. independent contractor, and no one factor stands alone in making this determination.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
As a small business owner, making cost cutting decisions may be critical to your survival. However, tax related decisions are one time when you should not be afraid to spend some money for the peace of mind to know that everything was done correctly in order to minimized your tax bill. This information is intended as a resource only and I recommend consulting with an accountant, or contacting the IRS for further clarification regarding the above topic.