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How to Reduce the Tax Risk of Using Independent Contractors

Posted by HomeWork Solutions on Nov 1, 2018 10:00:00 AM
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Classifying a worker as an independent contractor frees a business or family from payroll tax liability and allows it to forgo providing overtime pay, unemployment compensation and other employee benefits. It also frees the business from responsibility for withholding income taxes and the worker’s share of payroll taxes – household employers can legally omit withholding even for an employee.

For these reasons, the federal government views misclassifying a bona fide employee as an independent contractor unfavorably. If the IRS reclassifies a worker as an employee, your business or family could be hit with back taxes, interest and penalties.

Key factors

When assessing worker classification, the IRS typically looks at the:

Level of behavioral control. This means the extent to which the company or family instructs a worker on when and where to do the work, what tools or equipment to use, whom to hire, where to purchase supplies and so on. Also, control typically involves providing training and evaluating the worker’s performance. The more control the company or family exercises, the more likely the worker is an employee. For household employers think of it this way, if you hire a nanny would you let them do as they please or would you have some rules around how your child(ren) is cared for? … you’d have rules.

Level of financial control. Independent contractors are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, and market their services to other customers. Employees are more likely to be paid by the hour or week or some other time period; independent contractors are more likely to receive a flat fee. Domestic employees are hourly workers unless they have management duties like a Chief of Staff.

Relationship of the parties. Independent contractors are often engaged for a discrete project, while employees are typically hired permanently (or at least for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.

The IRS examines a variety of factors within each category. You need to consider all of the facts and circumstances surrounding each worker relationship. If you are truly unsure you can submit a form SS-8 to the IRS and have them decide for you.

Protective measures

Once you’ve completed your review, there are several strategies you can use to minimize your exposure. When in doubt, reclassify questionable independent contractors as employees. This may increase your tax and benefit costs, but it will eliminate reclassification risk.

From there, modify your relationships with independent contractors to better ensure compliance. For example, you might exercise less behavioral control by reducing your level of supervision or allowing workers to set their own hours or work from home (hint: Do these sound like something you would let a nanny or caregiver do? Unlikely).

Also, consider using a full service staffing agency. Workers leased from these firms are employees of the agency, which is responsible for taxes, benefits and other employer obligations. It is worth doing the math when considering a full service agency. They have overhead costs and profits to manage meaning you may end up spending more than a private direct hire.

Handle with care

Keep in mind that taxes, interest and penalties aren’t the only possible negative consequences of a worker being misclassified. In addition, your business or family could be liable for employee benefits that should have been provided but weren’t. Contact us if you have questions about worker classification.

Topics: CPA, agency, nanny, senior

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