By Ben Kinsey, CPA
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Are you willing to gamble with the IRS on Contractors versus Employees, it can be a business killer if you Lose? When should you hire an Employee versus a Contractor? “Do You Know the Rules that determine and Independent Contractor?
Are they an Employee or Independent Contractor? Know the Rules the IRS encourages all businesses and business owners to know the rules when it comes to classifying a worker as an employee or an independent contractor. An employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Employers normally do not have to withhold or pay any taxes on payments to independent contractors. Here are two key points for small business owners to keep in mind when it comes to classifying workers:
1. Who is in control? The relationship between a worker and a business is important. If the business controls what work is accomplished and directs how it is done, it exerts behavioral control. If the business directs or controls, financial and certain relevant aspects of a worker’s job, it exercises financial control. This includes: The extent of the worker’s investment in the facilities or tools used in performing services the extent to which the worker makes his or her services available to the relevant market How the business pays the worker and the extent to which the worker can realize a profit or incur a loss.
2. How is the Relationship Perceived? How the employer and worker perceive their relationship is also important for determining worker status. Key topics to think about include:
- Written contracts describing the relationship the parties intended to create
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- The extent to which services performed by the worker are a key aspect of the regular business of the company
- The extent to which the worker has unreimbursed business expenses could be a determining factor Cross References: Mescalero Apache Tribe, 148 T.C. No. 11, April 5, 2017.
If a worker treated as an independent contractor is later classified by the IRS as an employee, the employer is liable for taxes that it should have withheld from the employee’s wages. IRC section 3402(d) allows the employer in this situation to escape tax liability to the extent it can show the worker paid tax on his or her earnings. The taxpayer, in this case, treated some of its workers as employees and other workers as independent contractors. During an employment audit, the IRS determined a number of workers treated as independent contractors were in fact employees and assessed a tax deficiency against the employer for unpaid taxes. The employer disputed this classification but nevertheless proceeded to ask each affected worker to complete Form 4669, Statement of Payments Received, which allowed the employer to escape tax liability to the extent of the amount of taxes paid by each worker. However, the employer was only partly successful because 70 of the former workers had moved and the employer could not locate them. As a result, the employer could not secure executed Forms 4669 from those workers. The employer then tried to get this information from the IRS because the IRS knows whether each of the workers filed individual tax returns, how they reported their income, and how much tax they paid. The IRS denied this request on the grounds that it is prohibited from disclosing taxpayer information to third parties under IRC section 6103. The employer then asked the Tax Court to allow this information to be disclosed.
Here’s What the Court Determined - The court said that one exception to the
non-discloser rules is IRC section 6103(h)(4) which states that a disclosure is
allowed in a judicial tax proceeding if the return information directly relates
to a transactional relationship between a person who is a party to the
proceedings and the taxpayer which directly affects the resolution of an issue
in the proceedings. The court said that a worker’s tax records would
contain evidence of how the worker viewed his or her tax status. If the worker
reported income as self-employment income and paid taxes as such, that would
tend to show whether the worker considered himself or herself an independent
contractor or an employee. Such information would directly relate to his or her
transactional relationship with the employer. Thus, such worker would be considered a person who is a
party to the proceedings in a worker classification dispute. The court said
that if the workers did indeed pay their tax liabilities, then the employer’s
IRC section 3402(d) defense would be proved and would be entirely resolved.
Thus, the worker’s return information is disclosable under IRC section
6103(h)(4)(C). Editor’s Note: Much appreciation to Fellowship Members Rick and
Linda Odemar for this contribution to our knowledge.
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