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Using Independent Contractors? Why your business should use caution.

February 25, 2016 | By More

contractor-vs-employeeIt is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors.

The IRS states that generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.

Michael Beauchemin of Richard A. Beauchemin, CPA / Carolina Accounting & Tax Service, PLLC in Charlotte NC, delves deeper into this confusing topic that is fraught with pitfalls for business owners.

Michael: In fiscal year 2015 the US Department of Labor’s Wage and Hour Division investigation into employer misclassification resulted in more than $74 million in back wages owed for more than 102,000 workers.
Businesses subject to investigations by the Wage and Hour Division (WHD) crossed the full spectrum of industry sectors. Included sectors (but not limited to) were construction, hospitality, janitorial, temporary, day care and textile industry.

One of the key initiatives that led to WHD’s success is the Department of Labor’s Misclassification Initiative. The WHD has signed agreements with more than half of the states with the “specific and mutual goals of providing clear, accurate and easy-to-access outreach to employers, employees and other stakeholders, and of sharing resources and enhancing enforcement by conducting investigations and sharing information consistent with applicable laws.”

Government Policy Leading to Fissuring…What the Heck is Fissuring?
Fissuring is simply the breaking of the workforce relationship between a company and its workforce.
Additional reporting requirements and compliance to the Affordable Care Act have led companies to rethink their workforce management. Many companies contracted out or shed activities to be performed by the business. These can include the use of temporary agencies, subcontractors, third party management, labor brokers, licensing and other options that allows them to downsize.

This fissured employee relationship between workers and businesses concerns the WHD. Fissuring can lead to misclassification of workers as independent contractors. Because employers do not pay payroll taxes for independent contractors, misclassifying workers is a scheme for circumventing payroll taxes.

Why Does it Matter if I Misclassify a Worker
It matters a great deal. If the WHD reclassifies your workers, the back taxes owed and penalties are astronomical. For businesses that filed 1099s and non-willfully misclassified workers the penalties are:

  • Employee Federal Taxes – 1.5% of wages paid dating back to 3 years
  • Employees’ FICA taxes (Social Security and Medicare Taxes) – 20% dating back 3 years
  • Employer’s FICA taxes (Social Security and Medicare Taxes) – 20% dating back 3 years
  • Penalty – 100% of Employer’s FICA taxes

If it is determined to be willful the penalties are significantly more severe:

  • Employee Federal Taxes – 100% of federal income taxes owed dating back to 3 years
  • Employees’ FICA taxes (Social Security and Medicare Taxes) – 100% dating back 3 years
  • Employer’s FICA taxes (Social Security and Medicare Taxes) – 100% dating back 3 years
  • Penalty – 100% of Employer’s FICA taxes.

Additionally, you may owe state penalties, FUTA and SUTA taxes, penalties for failure to file W2s or 1099s and interest.

How Does the US Department of Labor Define an Employee Verses Independent Contractor
When the WHD initiates an investigation they will use six factors to determine if a worker has been misclassified. These are:

  1. Is the worker an integral part of the employer’s business
  2. Does the worker’s managerial skill affect his or her opportunity for profit and loss
  3. Relative investment of the worker and employer
  4. The worker’s skill and initiative
  5. The performance of the workers relationship with the employer
  6. Employer control of employment relationship.

Safe Harbor §530 May Be Your Savior
Section §530 may provide relief and provide an out to not pay employment taxes for misclassified workers. The employer must meet three criteria:

  1. There has to be a reasonable basis for not treating workers as employees. This can be the result of:
    1. Judicial precedent, published rulings or technical advice;
    2. A past IRS audit where there was no tax assessment for treatment of workers holding similar positions; or
    3. An industry-wide, long-standing practice for workers with similar positions being treated similarly.
  2. The employer must have treated all current workers and previous similar workers as independent contractors beginning after December 1977.
  3. The employer must have filed Form 1099-MISC for each worker, if one was required.

Relief through the Voluntary Classification Program (VSCP)
For any business concerned they misclassified workers the IRS is offering an opportunity for businesses to reclassify workers at greatly reduced penalties:

  • You only have to pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year. (Yes, only 10% for the most recent tax year and not the past three years). This is determined using reduced rates of section 3509(b) of the Internal Revenue Code.
  • You will not be liable for any interest and penalties on the liability.
  • Finally you will not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified for the previous years.

To participate, a company needs to apply using form 8952, Application for Voluntary Classification Settlement Program. The application should be filed at least 60 days prior to the date the taxpayer wants to begin treating its workers as employees.

Contributed by Michael Beauchemin – MBA
Richard A. Beauchemin, CPA/Carolina Accounting & Tax Service, PLLC is located in Charlotte, North Carolina. For more information or to contact Michael Beauchemin, visit http://CarolinaAccounting.com

Article information should not be used exclusively to make legal, financial or tax decisions. Because laws and rules can change frequently, topics may not always be updated to reflect these changes or may not apply to your unique situation. It’s prudent to seek out the advice of a professional for your specific needs.

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Category: IRS Problems

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