Your hiring practices could have tax consequences Tax Matters by David A. Katzman In these tough economic times, many business owners are looking for ways to cut costs. Naturally, altering payroll expenses through a hiring freeze or layoffs could be considered. In such instances, outsourcing work may be required. If you make this choice, however, your arrangement must adhere to certain Internal Revenue Service (IRS) guidelines regarding the classification of an employee versus an independent contractor. Unfortunately, these guidelines can be ambiguous and fact specific—and misclassification can be costly. In general, you are responsible for withholding federal income tax, Federal Insurance Contributions Act (FICA) tax and Medicare tax, if a worker is considered your employee. In addition, you must pay your company’s matching share of FICA and Medicare taxes on wages, as well as Federal Unemployment Tax Act (FUTA) tax and State Unemployment Tax (SUTA). Usually, you are also obligated to provide the fringe benefits offered to other employees. If a worker is an independent contractor, your only obligation is to send Form 1099-MISC to any contractor who was paid $600 or more. If you misclassify a worker, you could be held liable for unpaid taxes and benefits. Unfortunately, there is no uniform definition for worker classification. You must make your determination based on a preponderance of evidence generally clustered into three main categories, including behavioral control, financial control and the relationship of the parties. Behavioral control Do you have control or the right to control how the individual performs assigned work? If so, this would be an indicator that the person is an employee. On the other hand, if you leave the details of completion up to the individual, this could help establish an independent contractor relationship. Examples of specifics that may establish an employee relationship are prescribing where and when the work is done and what equipment is used. Financial control Who controls the business side of the work? If the individual has an investment in their business and incurs some unreimbursed expenses, this could help establish an independent contractor relationship. If you pay all expenses and assume the business risk, an employee-employer relationship could be established. Relationship of the parties How do you define your business relationship? If you pay benefits, such as vacation pay or insurance, this could help build a case for an employer-employee relationship. On the other hand, if you simply have a business contract outlining expectations, this could help establish an independent contractor relationship. There are some exceptions to consider, as well. Certain types of workers may be classified as “statutory employees,” which means you are responsible for social security tax collection but you are not necessarily required to treat them as employees for other purposes, such as fringe benefits. Examples could include life insurance salespeople, home workers, and some fulltime salespeople. Another special category is “statutory independent contractors,” which often includes real estate agents and other similar groups. Some other categories of workers are subject to special rules, as well. For example, corporate directors are not employees in their capacity as directors, and partners of an enterprise organized as a partnership are treated as self-employed persons. If doubt remains about an individual’s classification, you may ask the IRS for a ruling by filing Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” In the event of a misclassification, you may appeal for tax-liability relief under Section 530 of the 1978 Revenue Act. However, this protection applies only if you, as the employer, filed all federal returns consistent with treatment of the individual as an independent contractor; treated all similarly situated workers as independent contractors; and had a “reasonable basis” for not treating the worker as an employee. As you can see, worker classification is not clear cut. If you have questions about a worker’s status, a tax professional can help you make a determination. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.