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Small Business Tax Tips: Independent Contractors vs. Employees

Written by Eva Rosenberg on September 19, 2013 in Small Business  |   No comments

Doing small business payroll can be very complicated, even if you’re only paying one person. Taxes can be complicated, too: you need to register with the IRS and with your state payroll tax department, you need to deal with a lot of paperwork and calculations,…

small business payroll, small business taxDoing small business payroll can be very complicated, even if you’re only paying one person. Taxes can be complicated, too: you need to register with the IRS and with your state payroll tax department, you need to deal with a lot of paperwork and calculations, and you typically need to make payments to the IRS and state after each payroll.

When you (inevitably) make mistakes, you can face high penalties. To top it all off, you may need to hire someone to do your payroll to help you avoid issues with the IRS.

It can be a headache, but payroll is a necessary part of owning a small business. When you have people working for you in your facility or home, either full-time or part-time, you need to put those people on payroll. While you can try to get away with calling them freelancers or contractors in an attempt to avoid doing so, if they work for you and use your facility, your tools, and your equipment (computers, phones, vehicles, toolboxes, and so on), they may be your employees.

The IRS uses a set of 20 common law rules to determine whether or not a worker is an employee. The key issues are the amount of control the employer has over the worker and the work done; whether the worker can sub-contract the work to someone else or must only do it himself or herself; and risk of loss. Does the worker have a financial investment that he or she stands to lose? For example, does the worker have to pay rent on a space in a hair salon even if he or she doesn’t use it? Does the worker have to buy his or her own computer or tools? Does the worker have to pay for his or her own training?

To not be considered an employee, your independent contractor may need to have his or her own business license, work for several other people. Having a business card or website making his or her products or services available to other people or businesses is also helpful in determining whether your worker is an independent contractor. Even then, you may have the IRS still consider people that come and work at your office location as employees.

It helps if the worker is set up as a limited liability company (LLC), partnership, corporation, or S corporation.

(Just don’t get the idea that you should have the people you hire set up companies in order to avoid having to classify them as employees. )

If you find that you’ve been treating employees as freelancers, you may still be able to correct your error without paying a lot in penalties. The IRS has a special amnesty program for employers who have been issuing 1099-MISC forms for these workers. The Voluntary Classification Settlement Program (VCSP) program will only cost you 10 percent of one year’s payroll taxes instead of 100 percent of three years’ taxes (plus penalties and interest).

Unfortunately, there is no state equivalent, so you may find yourself facing state taxes and penalties. However, they’ll typically be a lot lower than the IRS taxes. Talk this over with your tax professional before making any decisions about participating in the VCSP.

These are treacherous waters to navigate, so please be sure you know your way. Consider enlisting the help of a tax professional if you have questions about independent contractors and employees to help you avoid any tax issues down the road.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.

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