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How Should NonProfits Classify Workers?

"Independent Contractor" vs. "Employee"
How to Avoid Crippling IRS Penalties
by: Paul Tulenko: Small Business Expert

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Here's the scenario: the IRS just completed an audit of your small business, and you have been informed that you owe $28,953 in back taxes and over $10,000 in penalties. You have 10 days to pay.

Sounds like another one of those, "I forgot to pay," deals, right? Wrong! This is a case of big brother, in the form of the IRS, making an independent and biased judgment on the status of a person you hired to do a job, an independent job. You hired the person as an independent contractor, but the IRS has now made a determination that they are really employees, and you should have been withholding taxes and paying the government all these years. Scary? Yes! Here's how it works, what is going on in Congress, and what you should be doing about it RIGHT NOW !

FUZZY IRS RULES: The IRS has dictated a very fuzzy set of rules you must abide by if you wish to claim a worker as an independent contractor. The rules are couched in such a manner that it is just about impossible to meet the test without a challenge from the IRS. Therefore, that person you hired to clean pools or carpets or to sell goods and services could be classified as an employee, not an independent contractor. The really difficult part to swallow is that the IRS just about has the final say-so, and unless you have a lot of money to spend on legal assistance, you will have to pay.

CLAIMING INDEPENDENT STATUS: Just because the person you hire has a business license, a state tax certificate, pays worker's compensation, is insured and has a host of other papers does not necessarily qualify that person for independent contractor status. It's the job he or she does for you that counts, and that classification is open to interpretation by the IRS.

WHAT THE IRS CAN MAKE YOU DO: The IRS can determine the individual you hired as an independent contractor is an employee. This means you should have been paying your shar e of medicare, social security, unemployment taxes, health insurance and other benefits on each of these 'employees.' In addition, you should have been withholding and depositing the federal income taxes on that individual, and since the IRS has determined that you are the taxpayer, you are responsible for the entire amount. So pay up!

At the same time, the IRS will send notice to the individual that they have determined the person is an employee, and as such must prove they paid taxes based on that fact, not on the independent contractor status. What this means is the money the individual received cannot go into the operation of the business, but must be declared a salary. If the individual wants to claim expenses against that salary, then they must file an amended return for each and every one of the years the IRS determines appropriate. Do you have all those records? Can you prove how you spent every penny? If not, you, as an adjudged 'employee' may have to also pay back taxes and penalties.

ONE WAY OUT: There is an out, and it's one the IRS doesn't like to do. You may petition the IRS to make a determination on whether the 'job' you are trying to fill is an independent contractor position or an employee position. The IRS has a form for this request, but you will have to call and request they send you one. It's not easily available, and I believe they change the name and number of it every year.

When the IRS finally makes the determination, they have to stick with it, and you are safe . . . at least until they change the rules again. When you receive your authorization, protect it like it is money. It is!


INDEPENDENT CONTRACTOR VS. EMPLOYEE
The "Common Law Rule" Applied by the IRS in determining Status

Below are the Common-Law Rules (formerly Twenty Common Law Factors) from the IRS. They help employers correctly classify workers as employees or independent contractors. They also help independent contractors determine if they've been correctly classified or not. Please be sure to check for the latest update at the IRS site.

COMMON-LAW RULES

To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties as shown below.

Behavioral control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of--

Instructions the business gives the worker. An employee is generally subject to the business' instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:
  • When and where to do the work
  • What tools or equipment to use
  • What workers to hire or to assist with the work
  • Where to purchase supplies and services
  • What work must be performed by a specified individual
  • What order or sequence to follow
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.

Financial control. Facts that show whether the business has a right to control the business aspects of the worker's job include:

The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.

The extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.

The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.

The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.

Type of relationship. Facts that show the parties' type of relationship include:
  • Written contracts describing the relationship the parties intended to create.
  • Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
  • The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.
  • The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

IRS help. If you want the IRS to determine whether a worker is an employee, file Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. Click Here to go to the IRS's download page. Hint: to open the link in a new (full) window, click your mouse's right hand button on the link and choose the appropriate choice.