Many business taxpayers struggle year after year trying to determine whether individuals performing work for the company are employees or independent contractors. The determination of whether an individual is an employee or an independent  contractor  imposes  different  reporting  requirements  on   the taxpayer  and,  where the individual is an employee, requires the taxpayer to act as a fiduciary in the  collection  from  the  employee  and  the  taxpayer of FICA  and  withholding   taxes   and   paying   the   withheld   amounts  to  the government.

Employee versus Independent Contractor:

Distinction: The  determination  of  whether  an  individual  is  an  employee or an independent contractor is critical in ascertaining the taxpayer's duties and obligations to the government. Erroneously treating an  individual  as  an  independent  contractor rather than an employee could  result  not  only  in the  imposition  of  the  employment taxes on the taxpayer but also interest and penalties on  the  failure  to  timely  deposit the  taxes   due,  failure  to  file  returns  penalties,  and   responsible   party  penalties. However erroneously treating an individual as an employee rather than an independent contractor will result in the taxpayer incurring additional expenses and the potential inability of the independent contractor to deduct his/her expenses incurred in connection with the rendering of services to the taxpayer. For these reasons, it is important that the taxpayer correctly determines an individual's status at the time the relationship commences.

The following factors are indicative that a worker should be considered to be an employee:

• Requiring the worker to comply with another persons' instructions about when, where and how to work.
• Training the worker to perform the required services in a particular method or manner.
• Integrating the worker's services into the operations of the business so that the worker is subject to direction and control.
• Requiring the worker to personally perform the services as opposed to the work being able to be performed by others who work for the worker.
• Hiring, supervising, and paying assistants.
• A continuing relationship between the worker and the person(s) for whom services are performed, even if the work is performed at irregular intervals.
• Setting the hours of work for the worker.
• Requiring the worker to devote substantially full time to the business of the person(s) for whom services are to be performed.
• Requiring the work to be performed on the premises of the person(s) for whom services are to be performed. Work done off the premises, while indicating some freedom from control, may not mean that the worker is not an employee.
• Requiring or retaining the right to require the work to be performed in a set order.
• Requiring that oral or written reports be submitted.
• Paying by the hour, week or month.
• Paying the worker's business and/or traveling expenses.
• Furnishing significant tools and materials.
• The right to discharge the worker, or the worker's right to terminate the relationship, at any time without liability.

• The worker hires, supervises, and pays other assistants if the worker is responsible only for the attainment of a result and not the manner in which the result is attained.
• Paying by the hour, week or month where the method of payment is a convenient way to pay a lump sum agreed upon as the cost of a job, or paying by the job or a straight commission.
• Maintaining a separate office.
• The worker realizing a profit or suffering a loss as a result of his/her services.
• If the worker performs more than de minimus services for a number of unrelated parties at the same time.

If the worker's services are available to the general public on a regular and consistent basis.

Worker's Reporting Requirements
If a worker is an employee, he must provide the employer with Form W-4 and Form I-9, as well as any other documentation reasonably required by the employer. If the employer does not reimburse the employee for expenses incurred in connection with the performance of his job, the employee may deduct these expenses on his personal income tax return as an itemized deduction to the extent they exceed 2% of his adjusted gross income. None of the amounts paid by the employee for social security and medicare taxes are deductible, and all health insurance premiums paid by the employee can only be deducted as a medical expense on the itemized deduction schedule.

If the worker is an independent contractor, he must provide the employer (used in this paragraph to refer to the company for whom he performs services) with Form W-9 as well as any other documentation reasonably required by the employer. The independent contractor must include all monies paid to him on Schedule C, whether or not Form 1099-MISC is filed for him for the year and including all amounts paid for out-of-pocket expenses. The independent contractor may then deduct from the amounts received all expenses incurred by him in connection with obtaining the income. One-half of the self-employment tax is deductible from the independent contractor's income in arriving at his adjusted gross income. In addition, the independent contractor may be able to deduct a portion of health insurance premiums paid by him for himself and his family (based on an escalating percentage of the premium; the balance of the premium can be carried to the medical expense portion of the itemized deduction schedule) in arriving at adjusted gross income.

Employer's Reporting Requirements
Employers are required to obtain Form W-4 and I-9 from each employee they hire. Depending upon the total payroll taxes withheld, employers must deposit the payroll taxes withheld on either a monthly or semi-weekly basis. Some employers may be able to pay the payroll taxes quarterly if the total payroll taxes for the quarter do not exceed $2,500; some may be required to deposit the payroll taxes the next banking day if the payroll tax liability is $100,000 or more. On a quarterly basis, employers must file Form 941, Employer's Quarterly Federal Tax Return, as well as a state unemployment tax return (if applicable), and make a federal unemployment tax deposit when the accumulated liability exceeds $100. On an annual basis, employers must file Form W-2, W-3, and Form 940, Federal Unemployment Tax Return.

Failure to timely deposit taxes results in the following penalties (the percent is applied to the amount of the unpaid taxes):

2% -deposits made 1 to 5 days late

5% -deposits made 6 to 15 days late

10% -deposits made 16 or more days late; also applies to amounts paid within 10 days of the date of the first notice sent by IRS requesting payment of the taxes due, deposits made at an unauthorized financial institution, paid directly to the IRS when required to be deposited with a financial institution, paid with the quarterly tax return (with certain exceptions), and amounts to electronic deposit requirements but not deposited using the electronic federal tax payment system

15% -amounts still unpaid more than 10 days after the date of the first notice sent by IRS requesting payment of the taxes due or the day on which you receive notice and demand for immediate payment, whichever is earlier.

In addition to penalties on the failure to timely and correctly deposit payroll taxes, there is a penalty of 5% of the unpaid tax due for each whole or part of a month a return is not filed when required (up to 25% of the tax due) PLUS a penalty of .5% of the unpaid tax due for each whole or part of a month the tax is paid late.

If the worker is an independent contractor, you must have a completed and signed Form W-9 on file from each of your subcontractors including their name, address and social security number.

Form 1099-MISC, Miscellaneous Income, must be filed with respect to nonemployee compensation of $600 or more for the year, as well as other monies paid to third parties other than corporations. The $600 threshold includes all payments to the third party, including expenses incurred by the third party which you may have reimbursed to them.

There is a three tier system of penalties with respect to 1099's: a $100 penalty per payee for whom a required 1099 is not filed, a $50 penalty per incidence of incorrect information reported on each 1099, and a $50 penalty per missing tax identification number.

More important than these penalties, however, is that the payor is liable for backup withholding on all amounts reportable to each payee where the payee fails to furnish his/her taxpayer identification number, where the IRS has notified the payor that the tax identification number is incorrect, or where the IRS has notified the payor that the payee is subject to backup withholding. In such an event, if backup withholding has not been withheld from payments made to the payee, the payor is liable for the backup withholding at the rate of 31% of the amount paid to such a payee. Penalties and interest may be imposed on top of this. Penalties for intentional disregard of the filing requirements may be even more severe.

Conclusion: Companies that utilize the services of independent contractors should review the nature of the relationship on a consistent basis using the factors set forth above, and should be adamant in all instances in conforming to the filing and deposit requirements set forth by the I.R.S. in order to minimize the imposition of penalties.
 

In the News:

Pay by Internet: As of September 7, 2001, individuals and companies can now pay all federal taxes on a secure Internet site; I.R.S. officials believe the use of the Internet to pay taxes promises greater convenience for taxpayers and reduces paperwork. Taxpayers must enroll in the system by going to the Internet site - www.eftps.gov and following the prompts. After enrollment the taxpayer receives a confirmation kit by mail which includes the taxpayer's password for use of the Internet site, as well as a personal identification number. Taxpayers receive confirmation that the I.R.S. has received a payment in the form of a printable acknowledgment number. In addition, taxpayers can review their payment history (up to 1 year for individuals or 3 months for businesses) and can schedule payments in advance.

You may have a fear of the I.R.S. having access to your bank account to make unauthorized transfers. We don't perceive and are not aware of any additional rights this may give the I.R.S.; that is, in the event of disputed taxes the I.R.S. would still need to go through the same collection process.

The government giveth, and the government taketh away: The I.R.S. has begun notifying some Social Security recipients that 15% of their monthly social security benefits are being docked for payment of back taxes. Although the Federal Payment Levy Program began in July 2000, this is the first time that Social Security checks are being affected. The GAO expects that 65% of back taxes collected by the program will be received as a result of levying Social Security benefits.
 

Tax Quip:
 
 

 The  above  is   general  information  only  and  should  not  be  construed  as specific tax advice.  
 Please consult with your tax advisor. 
    
 

 Copyright 2001. Daniel P. Ehmke, C.P.A., P.A. Users are not to publish, retransmit, redistribute or otherwise reproduce documents without prior written consent (Daniel P. Ehmke, C.P.A., P.A., www.EhmkeCPA.com).