The ins-and-outs of employees vs outside contractors
Employee vs Independent Contractor – Overview
If you run a business and get support from workers other than yourself, you have probably asked yourself the question “should I pay these people as employees or as outside contractors?” In order to convince yourself that you made the correct decision, maybe you thought that since you only use one person or just pay for part-time help that you qualify to pay your workers as independent contractors. To save money and hassle, some people lean toward the latter and learn they made the wrong decision the hard way.
Most people paying for help prefer to pay someone as an independent contractor. It reduces issues some employers have with employees and saves the payor from having to pay payroll taxes. When determining how a worker should be classified, the taxing agencies (IRS or State) look to see if the workers were paid as an outside contractor when they should have been paid as an employee. If they make the determination that the workers should have been employees, they will go after the payor for payroll taxes, statutory withholding, penalties and interest. This could amount to a very large sum of money. Especially if the payor has several workers.
The taxing agencies do not care if someone is being paid as an employee when they should have been classified as an outside contractor. Again, they are looking to collect payroll taxes from the person or company they consider to be an employer. As far as exposure to examination by the taxing authorities, paying someone as an employee over an independent contractor is the safe harbor.
There are specific rules that dictate whether you should pay someone as an employee or as an independent contractor. The problem is, if you ask the IRS they may give you a different answer than the State. For instance, the IRS developed and uses a 20-Factor Test determine who should be classified as an employee.
On the other hand, the California Supreme court recently made it more difficult for business people to pay their workers as independent contractors. The Court determined that in order to classify a worker as an independent contractor, a business owner must show that the worker is free from the control and direction of the employer, and that he or she performs work outside the business owners principal line of work. To use an analogy, a lawyer hiring a per-diem associate, a research assistant or a part-time paralegal (who each in essence provide legal support) should all be considered employees. On the other hand, if the same lawyer hired a plumber to unclog the sink in the office kitchen, he would pay the plumber as an independent contractor.
The California Supreme Court made their ruling based upon litigation stemming from payments to drivers from app-driven providers such as Uber and Lyft, but it is important to know that the final result has far-reaching implications affecting anyone that pays $600 or more to a person each year.
How to Pay an Independent Contractor
If you determine that someone should be paid as an independent contractor, you want to be sure you do so properly.
The basic rules are as follows. If you pay a person, non-corporate entity or legal corporation $600 or more in a given calendar year (assuming they are not an employee), you need to obtain a signed and dated IRS Form W-9 and issue a corresponding 1099.
Before you pay an independent contractor anything, you should obtain a signed and dated IRS Form W-9. In this form the service provider will enter their name (or business name if you are paying an entity) their EIN or Social Security number, and their mailing address. This form has a few other lines and boxes to enter information under certain circumstances.
The IRS Form 1099 (most likely 1099-MISC) to be issued will include information provided in the W-9 including the recipient’s name, taxpayer ID number, and total amount paid in the given tax year. For this type of 1099, the forms must be completed, postmarked and mailed to the recipient no later than January 31st of the year following the year in which payments were made. The forms must be filed with the IRS (and if done so electronically must also be filed with some States) by the same date. Under certain circumstances, a filing extension may be requested using IRS Form 8809.
Reporting payments to independent contractors is important. If you fail to do so, penalties may be assessed. In addition, if a taxing agency decides to conduct an audit to determine if your worker classification is correct, your exposure is greater if you did not pay your independent contractors correctly.
Payroll taxes – a brief overview
Assuming you “took the plunge” and decided to pay your workers as employees there is a whole set of different rules you need to follow to be in compliance.
These rules include several items such as obtaining an IRS Form W-4 (to determine withholding), and an I-9 (to prove employment status) which will not be addressed in this article as there is way too much to cover here. For this reason, you should consult a payroll professional (i.e. employment attorney, payroll processor, etc.) to determine which steps you should take when becoming an employer and hiring new employees.
What we are focusing on here is staying in compliance with regard to payroll taxes. Depending on how many employees you have and how often you pay them will determine how often you need to make payroll tax deposits. Whether or not you had payroll in a given quarter, you are required to report the amount paid (even if the amount was $0) via Federal and State payroll tax returns (Form 941 for the IRS). In addition, you must file an annual payroll return (IRS Form 940) to report Federal unemployment tax information.
Are you processing payroll correctly?
Processing payroll is a lot of work for anyone to handle. Especially if you are someone running a business or working full-time in a profession other than payroll processing.
If you pay someone wages and do not report the information timely, substantial penalties will apply. Even worse, if you fail to make payroll tax deposits, you can be held personally liable for not only the employer portion of the payroll taxes but also the employee’s portion of the payroll taxes and income tax withholding.
For these reasons, you have two choices. Learn how to process payroll correctly including the related filings and tax deposits or find a company to do this work on your behalf. If you choose to use an outside payroll provider, be sure they know what they are doing.
Assuming you pay the provider directly for the net wage amounts, payroll tax liability amounts (both employer and employee) and whatever they charge you to process the payroll, you are trusting that they (1) are paying your employees their wages and (2) are making the tax deposits timely and in full.
It is pretty easy to see if your employees are being paid as they will not wait 5 minutes to let you know that their check did not clear. On the other hand, if your tax deposits are not being made, it may take months or even longer to realize you have a problem. The worst part is, even though you paid the funds to the payroll processor, you are still liable.
Hire the right professional
We understand the importance of using the right payroll provider. This is why The Tax Resolution Institute has enlisted Paychex as our TRI Preferred Partner™ for payroll and 1099 processing.
If you currently process payroll or are considering reclassifying your workers as employees, we recommend you consider Paychex as your provider.
By mentioning that you were referred to Paychex by The Tax Resolution Institute, they will waive initial fees, provide discounts and submit some filing forms for free.
In addition, Paychex not only processes payroll, they also process W-9’s and 1099’s for independent contractors. In fact, if you prefer, Paychex will make payments to the providers and debit your account.
To discuss your options, use the link to enter some basic information and a Paychex payroll specialist will contact you accordingly.
Matthew Cohen is a partner at the Tax Resolution Institute.