There are a lot of myths about the subject and with 6,000 audits of mainly small businesses planned for this year the potential costs of 150% of the tax not deducted can be significant. So you need to understand the boundaries a little to avoid your staff being unexpectedly classified. Just a hint, the idea that you are safe as long as they aren’t in the office or are labeled as interns is purely a myth though having to work in the office is an important factor as it often leads to you controlling many aspects of their work. Lawyer Albert Rizzo gave a presentation at Brooklyn Business Library for NY State Small Business Development Center which covered some of the key concepts.
The costs to the business are higher for employees though basic income taxes have to be paid in the end for both situations. The apparent costs are also more obvious as you have to deduct tax before paying people and just the sheer form counts are much lower if you can keep everybody as an independent contractor so most small businesses try to classify people as independent contractors where possible. If they are employees then it isn’t the end of the world, you can use ADT or PayChex to handle the processing of deductions for much less than $100 per month per employee. You do have to make sure that you can manage to make the regular payment schedule associated with employees that these services will need to take from your account on schedule.
For the IRS the concept is in summary that the person is an independent contractor if the business has the ability to direct or control the end product but not the way the work is done. Now what does that really mean?
They look at the totality of a number of areas to try to see if the business has control over what they do and how they do it and hence are an employee:
- Control over Behavior
- Financial Control
- Type of Relation
In the area of behavior:
- The type of instruction given: Does the business control: Which tools to use, workers to hire, where to purchase supplies, who does which tasks, the order or sequencing of tasks?
- The degree of instruction given by the business – How specific is it?
- The evaluation system of the staff (Evaluation after a project looks like an independent contractor but periodic reviews are the actions of an employer)
- The training given
Are the financial aspects controlled by the business owner?
- Un re-embersed expenses such as advertising
- Significant investment such as tools and equipment
- Opportunity for profit or loss
- Service available to the market
- Method of payment
Type of relationship
- Written contracts
- Employee benefits
- Permanency of relationship
- Services as key activity of the business
In addition there are some exceptions, largely created by case law.
The following are treated for tax purposes as if they were employees and deductions have to be made:
- Drivers distributing for beverage companies, bakeries, laundries who are agents or paid on commission
- Full time life insurance agents selling for a single company
- Those working at home on goods which are supplied and returned to the business
- Traveling sales people
So for example you tell a building contractor to build a kitchen that has certain characteristics (The end product of the work) but you do not tell them how to do it (Where to buy grouting, in what order to build, who to hire) so they are not your employees. The plasterer owns his own equipment but his tasks are controlled by the contractor so he is an employee of the contracting firm.
It was clear from the Q&A at the end of the presentation that for a large proportion of startup businesses there have been oversights in classifying workers. One business owner had concerns about her interns who had not had deductions made and for which the business could potentially be liable. Another had brought a group of performers in from Canada and paid them without deductions and was now being asked to pay the tax on the full amount She had been paid. Clearly she was going to have made a significant loss on the venture and had no way or right to recover the money paid to the performers. I don’t suppose I need to spell out the moral of the tale! You can find similar events through the events list on the IRS site or Brooklyn SBDC. Further details on the question of independent contractor status are discussed at this page on the IRS site.