How to avoid IRS inquiries when using independent contractors

How to avoid IRS inquiries when using independent contractors

Getting to the bottom line with Dannible & McKee, LLP

Many construction companies use subcontactors rather than hiring employees to perform certain aspects of a job. These arrangements can save time, money and headaches. Take a look at some of the recordkeeping and financial differences:

With an Employee

• You must pay the employer’s half of FICA, as well as federal unemployment tax (FUTA).

• You are required to withhold federal income tax and the employee’s half of Social Security and Medicare (FICA).

• You must issue a W-2 form to the employee and send  copies to the IRS.

• Depending on your company’s policies and state and federal laws, you must generally provide fringe benefits such as health insurance, retirement plans, sick days and paid vacations.

• You are generally required to carry workers’ compensation insurance and other insurances.

With an Independent Contractor

• You generally don’t have to withhold taxes from the worker’s pay, you don’t owe the employer’s portion of FICA and FUTA and you don’t have to pay workers’ compensation.

• It is easier to engage workers for specific, short-term assignments so tailor work crews to fit your slow and busy seasons.

• You must issue the worker a Form 1099-MISC and file copies with the IRS if you pay the person $600 or more during the year.

• You aren’t required to provide fringe benefits. Subcontractors are responsible for keeping their own records, paying their own income and self-employment taxes and providing their own health insurance.

• You can reduce exposure to some types of legal actions, such as wrongful termination lawsuits.

When you compare the two, hiring subcontractors could be a better fit for your company. However, you should make sure your independent contractors really qualify for this status under the law. Your company can pay a heavy price if you treat an employee as an independent contractor without having a “reasonable basis” for doing so.

The IRS, DOL and other federal and state agencies routinely reclassify contractors as employees and the costs can be devastating to business owners. You may be required to pay a bundle in unpaid payroll taxes, benefits, interest and penalties.

Caution: There have been several highly publicized lawsuits filed against companies by independent contractors who claimed they were really employees. Disgruntled workers contact the IRS or DOL to complain that they are misclassified. This can open the floodgates to major problems for a company.

The issue is complicated, so consult with your CPA or contact us with questions.

A rule of thumb is workers are considered contractors if you have little control over the way they get the job done. The more you direct a worker, the more likely the IRS is to classify him or her as an employee.

Unfortunately, no single factor determines a worker’s legal status. The IRS looks at a number of issues, such as:

• Provision of tools: An employer usually gives tools, equipment and workspace to employees. In contrast, subcontractors often provide and invest their own money in equipment, tools and facilities.

• Offering services to the public: Subcontractors make their services available to the general public and are free to work for two or more businesses.

• Setting hours: Employees often have set work schedules, while contractors are allowed some flexibility. However, the IRS recognizes that some work, by its very nature, must be done at specific times.

• Hiring assistants: Employees don’t hire and pay anyone to help them do their jobs. But contractors often hire, supervise and pay their own assistants.

• Pay schedule: Employees are generally paid hourly or weekly, while contractors are paid by the job. It’s a good idea to require contractors to submit invoices since they provide proof of non-employee status.

To protect your company, it’s crucial to have written contracts with outside workers that clarify details of the relationship. Once you draft contracts that treat workers as independent contractors, live up to them. Resist the urge to supervise subcontractors the way you oversee employees.

Make sure to maintain good records. Obviously, you need to keep the worker’s taxpayer ID number and other information required by the IRS, but you should also keep items that help prove the person is self-employed (for example, business cards, a letterhead, invoices and record of advertisements placed online or in newspapers).

Your use of independent contractors should always be examined on a case-by-case basis and if they are to be treated as a subcontractor, there should be a legal document that outlines their duties and responsibilities. This document should be drafted or reviewed by an attorney who is familiar with construction law and signed by both parties.

The possible cost of misrepresenting employees as independent contractors can be staggering and could close a profitable company. Be sure that your company is not ruined by a misclassification.

Joseph A. Hardick, CPA, CCIFP is a tax partner with Dannible & McKee, LLP, a Syracuse, NY-based public accounting firm with more than 90 professionals. The firm has specialized in provided tax, audit and accounting service to the construction industry since its inception in 1978. For more information on this topic, you may contact them at 315.472.9127 or visit www.dmcpas.com . 

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