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Fight the ‘war of independence’ with IRS

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in Centerpiece,Small Business Tax,Small Business Tax Deduction Strategies

IRS websiteSmall business owners often clash with the IRS over the classification of workers. Usually, the employers claim certain workers are independent contractors; the IRS says they’re employees.

Strategy: If you’re challenged by the IRS, don’t throw up the white flag so fast. It’s an uphill battle, but you can prevail if you have a legitimate gripe and stick to your guns.

Here’s the whole story: If a worker is classified as a “common law employee,” you must withhold federal income tax and the em­­ployee’s share of Social Security and Medicare taxes (FICA). Even worse: You must pay the employer’s share of Social Security and Medicare taxes and the federal unemployment tax (FUTA). Finally, you must issue Form W-2 for the wages and send a copy to the IRS.

In contrast, if a worker qualifies as an independent contractor, your business doesn’t have to worry about federal income tax withholding, the Social Security and Medicare taxes, or FUTA. Nor do you have to provide expensive fringe benefits, like health insurance, that are offered to employees. But here’s the rub: If you improperly classify a common law employee as an independent contractor, your company could be hit with a bill for unpaid federal employment taxes, plus interest and penalties.

Essentially, it boils down to this: If you have little or no control over the way the worker gets the job done, he or she is an independent contractor. Conversely, if you have the legal right to control how the worker performs the job, he or she is an employee—even if you don’t actually exercise that right.

New case: An auto body shop in California employed seven mechanics, an estimator and two secretaries. Each of the seven mechanics had his own space in the shop in which to perform work, but they didn’t pay any rent. The taxpayer paid the mechanics weekly by check based on commissions and the type of work performed. As mentioned, three other workers were employed by the body shop: one estimate writer and two secretaries.

The body shop treated all the workers as independent contractors. To determine their proper status, the Tax Court looked at the following:

  • The degree of control exercised by the employer
  • Which party invests in work facilities used by the individual
  • The individual's opportunity for profit or loss
  • Whether the employer can discharge the individual
  • Whether the work is part of the employer’s regular business
  • The permanency of the relationship
  • The relationship the parties believed they were creating.

The Tax Court noted that all the factors are relevant and one is no more dominant than another.

It concluded that the seven mechanics were independent contractors, but the estimator and the two secretaries were employees. (Keller, TC Memo 2012-62)

Tip: Cut independent contractors more slack than regular employees. Define what needs to be done, but not necessarily how, when and where.

Online resource: Download a free white paper, "Independent Contractor or Employee? How to Make the Call" from The HR Specialist.

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