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Independent Contractors Or 1099 Employees – The Risks
The Independent Contractor status of workers is being seriously challenged by the IRS. Between 1988 and 1992 the IRS reclassified more than 400,000 Independent Contractors to employees and collected over $52.5 Million ($52,500,000) in back taxes. In 1992 alone the IRS conducted 1,700 audits of businesses, reclassified 90,000 workers and collected $19 Million ($19,000,000) in tax assessments. (Statistics from US Chamber of Commerce, 1993). If you are a businessman who utilizes Independent Contractors during the year, your business could be in jeopardy. Do not be lulled into a false sense of security by the IRS’s October 25, 1995 announcement that “Due to federal spending cutbacks, we will discontinue our long time practice of random tax return audits.”
Our subject here is NOT about “random audits.” It’s about a specific, identifiable targeted group. These audits have been very profitable to the US Treasury. It’s a hot issue and not about to be forgotten or relegated to the back burner any time soon. Stay awake on this one, folks! This article is not intended to be a negative shot at the IRS, but rather a warning to business owners who hire “Independent Contractors.” Be Aware and Be Prepared! Failure to do so could cost you a lot of money, a lot of grief, and possibly even your business.
Most business people want to play by the rules. But, WHAT ARE THE RULES in this game? If a worker is classified as an “Independent Contractor”, the business which hires him must file a Form 1099 with the IRS whenever the gross compensation for that person exceeds $600 in a calendar year. The Independent Contractor is then required to pay his own income taxes, Social Security taxes (called self-employment tax), Medicare, Unemployment taxes and worker’s compensation insurance premiums. Oh, and don’t forget the state income taxes (7.2% in Utah, up to 11.3% in California). If a form 1099 is completed and sent to an Independent Contractor somebody had better be paying the taxes. Obviously, the person who did the work and received the 1099 form is responsible for all the taxes due. It is his responsibility, but what if he doesn’t pay? What if he has no money, and no assets? He then becomes a very good candidate for status reclassification. What that means in plain English is, somebody is going to pay those taxes. Guess who? In this case the IRS will go after the person or business who issued the 1099 form. Businesses who “hire” or use the services of a subcontractor or “self employed” worker need to be very careful whose services they use and in what manner, or on what basis, they use these people. Business is no longer simple; even the most honest and well intentioned business owner can get caught in this trap.
You never meet the IRS on a level playing field, for they have too much staying power, too many assets to call upon. Even when you win, you lose. The time requirements of the battle, the emotional drain and trauma associated with the action are often devastating to both the owner and the business. Even large and substantial businesses that are financially solvent face imminent danger when faced with worker reclassification. And, if they decide to hire all the workers as employees, provide them with the employee benefits, pay withholding taxes, worker’s compensation, etc., they find that they cannot remain competitive in today’s market. As an example, a contracting company which used subcontractors found themselves in this pickle. They had been assessed $26,000 in worker misclassification taxes, along with $10,000 in interest plus penalties. They contested the IRS decision, went to court and “won” their case. In order to prosecute their claim against the IRS, they had to pay their attorneys over $16,000. Although the court found in their favor they are still waiting, over 18 months later, for their $26,000 refund from “winning” their case. They had excellent records, and all their subcontractors had signed well written Independent Contractor Agreements. They won the battle, but lost the war. The fight with the IRS drained their resources, dried up their cash flow and put them out of business.
Independent Contractors are very often entrepreneurs by nature and are very heavy on the independent part. They don’t want a boss to supervise them, and many are certainly responsible enough and skilled enough not to need one. Thank goodness for these craftsmen, especially the dependable ones. So you hire these mavericks, the job gets on schedule and you pay them. At the end of the year you send off a 1099 and the ball is in their court. Okay, what if he drops the ball and doesn’t pay, or doesn’t even file a tax return? We have already discussed the possible consequences of this scenario above and you know that this part of the story CAN get real ugly, real fast. Here are the possible costs that may fall to the “innocent,” or perhaps more accurately, the “uninformed” business owners: Hefty assessments which could go back several years and will include back taxes, interest and penalties, and both halves of social security and Medicare. These last 2 taxes alone presently total up to 15.3% of the employees income. Even if your Independent Contractor pays all his taxes, this still might not be enough to let the businessman off the hook. If a business uses what they think are “Independent Contractors” the IRS may determine whether this designation is correct. The first questions the IRS will ask is does the business have the right to CONTROL and DIRECT what the workers do. If so, the IRS may consider the workers to be employees and not Independent Contractors, and ZAP, reclassification occurs! In this case, the IRS will demand all the back taxes, penalties, interests, etc. which were discussed above. In cases, this additional burden is enough to put you out of business.
The IRS has a list of criteria from which it will determine whether the worker is an Independent Contractor or an employee. According to the IRS, none of the listed criteria is more important than the others, but rather it is the cumulative effect of the situation which determines the status of the worker. (In other words, the IRS doesn’t want to tell us which of the criteria are most important in making this determination). If the worker does the following, the IRS will classify the worker as an employee:
1. Must comply with the employer’s directions regarding the work;
2. Receives training from or under the direction of the employer;
3. Provides services that are dovetailed into the business;
4. Provides services that must be performed personally;
5. Cannot hire, supervise or pay his own assistants;
6. Has a continuing relationship with the employer;
7. Must follow set working hours;
8. Works full time for the employer;
9. Does all or most of his work on the employer’s premises;
10. Must do his work in the order outlined by the employer;
11. Must turn in periodic reports to the employer;
12. Is paid for time worked, weekly, monthly, etc.
13. Receives payments for travel and other business expenses;
14. Depends on the employer for his tools and materials;
15. Has no big investment in facility or tools needed for his work;
16. Cannot earn a profit or suffer a loss based upon his own services;
17. Works for only one employer or company at a time;
18. Does not offer his services to other companies or the public;
19. Can be fired by the employer;
20. May quit at any time without suffering any liability.
YOU CAN AVOID THESE PITFALLS
The IRS offers Small Business workshops. Call your local IRS office and ask for the dates, times and places. They also have written materials such as Publication 937; it free for the asking. Some companies during recent years have referred their workers to 3rd party payroll services who actually hired the worker and then leased him back to the client company. Under this arrangement, the worker is chosen by the company, but the 3rd party service pays his wages as directed by the client company. The payroll company issues the W-2 and withholds all state, federal and FICA taxes. This idea is certainly creative, But has not always held up to scrutiny in the courts, and frequently, tax liability has been extended back to the real employer. The Courts and IRS firmly believe that “if it looks, acts, walks and quacks like a duck, it is a duck.”
The “C” corporation is one of the oldest, most tried and tested business entities, and probably offers the best solution for this growing problem. Businesses should insist that all Independent Contractors they employ operate as a “C” corporation and not a sole proprietorship. When properly formed and organized, the corporation establishes a business relationship that will prevent reclassification under the IRS questions asked above.
“Wait a minute, not so fast, ” you say. What does becoming a corporation have to do with the questions asked by the IRS (listed above)?” The answer is a firm “everything,” if properly operated as a privately held corporation (for the “duck” test still applies). The worker is an employee of his corporation. The corporation, and not the worker is hired. Point by point, question by question, the party for whom the work is done and the worker are clearly separated, and will pass the IRS test with flying colors.
The corporation is its own entity, not to be confused with an individual or construed to be an employee. For example, corporate officers must not commingle corporate and personal funds. Billing statements must be issued by the corporation and not the individual. The worker becomes an employee of the corporation which pays him a salary and withholds all the appropriate taxes. Stockholder meetings must be held and accurate records kept. “When savvy business owners come to understand how this works, they will insist that all their independent contractors incorporate. Many California and Nevada business people have been using this package for years.” “Anybody who is in business today, earning a profit and paying taxes ought to have a Nevada corporation in their cash flow loop.” You may say, “Well, if all this is true, my CPA and/or attorney would have told me, and would have set up these necessary safe guards.” WRONG! Your attorney is trained to deal in history – he can defend your past actions. Neither law school nor the actual practice of law in today’s world prepares him to supervise your business and suggest ways to better protect yourself. In fact, when is the last time your attorney has called you and given a suggestion which has benefited you, or your business?
And, unfortunately, in most cases, your accountant has been reduced to a mere functionary, particularly with the increased use of computerized tax preparation programs such as Turbo Tax and others. Your accountant now merely plugs in your figures and the computer spits out the completed return. Also, did you know that your accountant is required to ask the IRS for an opinion letter in the event he disagrees with a deduction you want to use? Or, if he doesn’t have sufficient time to get the opinion letter, he has to send a letter with your return stating that he disagrees with the following deductions. I’m sure there are bigger red flags for the IRS, but I’d be hard pressed to find one. This letter will really open you up to the distinct possibly of an audit. And, it makes your accountant even more conservative with your return than normal. A business owner today who doesn’t know all the rules is like a person bowling in the dark. He has no idea what he is doing. Don’t bowl in the dark, become informed instead, because where the IRS is involved, what you don’t know can hurt you! You’re on your own out there. It’s a jungle, and you need all the protection you can get.
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