QuickBooks Tip: Employees vs. Independent Contractors
The days when a small business could ignore the risks of having misclassified workers are over.Â Unfortunately, some employers improperly classify their employees as independent contractors to avoid the pain associated with having employees, namely:
- Payroll taxes
- Minimum wage or overtime requirements
- Other wage and hour law requirements, like providing meal periods and rest breaks
- Reimbursable business expenses employees incur in performing their jobs
Additionally, employers don't have to cover independent contractors under workers' compensation insurance, and are not liable for payments under unemployment insurance, disability insurance, or social security.
It's true, the expenses associated with employees are high. However, the cost of misclassifying workers is even higher.Â If your contractors are determined to really be employees you will not only be required to pay the taxes and fees you should've, you may also be required to pay the employee's taxes as well.Â Not to mention the stiff penalties and interest that can be imposed by both federal and state agencies for violating the various laws.
This is no small matter and is on the radar of every government agency out there, all of whom are anxious to find additional revenue sources these days.Â The IRS estimates that one in seven U.S. employers is guilty of misclassifying some of its employees, resulting in a loss of more than $4.1 billion a year in tax revenues.Â These days the question is no longer "if" you'll get audited for employee misclassification it's "when".
For businesses facing an audit, the odds favor the IRS. A recent report found that 92 percent of the companies audited for "misclassification" were hit with significant penalties and assessed for back taxes. Between 1988 and 1995, the IRS audited more than 13,000 businesses, reclassified 500,000 of their independent contractors as employees, and levied $830 million in back taxes and penalties.
Making matters worse, sometimes the various agencies disagree.Â For instance, here in California there are several state agencies involved with the determination of independent contractor status:Â (1) the Employment Development Department (EDD), which is concerned with employment-related taxes, (2) the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers' compensation insurance laws apply; (3) the Franchise Tax Board (FTB), which is concerned with state income taxes; (4) the Division of Workers' Compensation (DWC), which is concerend with worker's compensation; and (5) sometimes even the Contractors State Licensing Board (CSLB), that also have regulations or requirements concerning independent contractorsÂ and it's not uncommon for one to rule that a worker is an employee while another rules that the same worker is an independent contractor.
Because the potential liabilities and penalties are so significant if an individual is treated as an independent contractor and later found to be an employee, each individual working relationship needs to be thoroughly analyzed to make sure every single worker is properly classified.Â Now is not the time to group classes of employees together.Â Just because one of your workers qualifies as an independent contractor, don't assume that all the others doing similar work will.
It all boils down to control - does your business have control or the right to control the worker both as to the work done and the manner and means in which it is performed? The IRS breaks control down into three categories:Â behavioral control, financial control, and relationship of the parties. It is very important to consider all the facts for every single one of your worker relationships - no single fact provides the answer.
These facts show whether there is a right to direct or control how the worker does the work.
- Instructions - if your business has the right to direct or control the work, even if you don't actually exercise the right, it can lead to an employee classification.Â Here are a few examples of what's considered control:
- how, when, or where to do the work
- what tools or equipment to use
- what assistants to hire to help with the work
- where to purchase supplies and services
- Training - if your business provides training about required procedures and methods it may be considered an indication that the business wants the work done in a certain way, which can lead to an employee classification
These facts show whether there is a right to direct or control the business part of the work. Here are a few questions to ask yourself:
- Does the worker has unreimbursed business expenses?
- Did the worker invest in the facilities used in performing services?
- Does the worker makes his or her services available to the other businesses?
- How do you pay the worker?
- Can the worker can realize a profit or incur a loss?
Type of Relationship
These facts show how the business and the worker perceive their relationship.
- Do you have written contracts describing the relationship the parties intended to create?
- Is the worker available to perform services for other, similar businesses?
- Do you provide the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay?
- How permanent is the relationship?
- Are the services performed by the worker a key aspect of your business?
You'd think that a written contract detailing that you and your worker agree that you are not creating an employer-employee relationship is all that's needed, but unfortunately this isn't the case.Â It may certainly help, especially is you subsequently issue a 1099 form instead of a W-2 form, but even this doesn't guarantee protection.
- If you decide to classify some or all of your workers as employees, this is what you have to look forward to:
- You must withhold income tax and your employee's portion of social security and Medicare taxes.
- You are also responsible for paying social security, Medicare, and unemployment (FUTA) taxes on your employees' wages.
- You must file a Form W-2, Wage and Tax Statement, showing the amount of taxes withheld from your employees' pay. The Form W-2 is used by employers to:
- Report wages, tips and other compensation paid to an employee
- To report the employee's income tax and Social Security taxes withheld and any advanced earned income credit payments
- To report wage information to the employee, the Internal Revenue Service and the Social Security Administration
QuickBooks handles W-2's differently based on which payroll subscription you've chosen.Â There are three options available:
- Basic Payroll:Â No tax forms, only reports that your accountant can use to prepare them
- Enhanced Payroll: Includes all federal and many state tax forms, you pay taxes and file forms
- Assisted Payroll: Intuit handles your payroll taxes for you
If you decide to classify some or all of your workers as independent contractors, there isn't as much paperwork but there are some reporting requirements:
- You may be required to file Form 1099-MISC, Miscellaneous Income, to report what you have paid to your independent contractors.Â The Form 1099-MISC is:
- Used to report payments made in the course of a trade or business to another person or business who is not an employee
- Required among other things, when payments of $10 or more in gross royalties or $600 or more in rents or compensation are paid
- Provided by the payer to the IRS and the person or business that received the payment.
- You do not have to withhold taxes from your independent contractors' pay.Â They are responsible for paying their own income tax and self-employment tax.
If setup properly, QuickBooks can help you track all the information needed for 1099's.Â Here's how:
- Turn on 1099 preference
- Edit > Preferences > Tax: 1099 > Company Preferences tab, check box next to Do you file 1099-Misc forms and select accounts you use to pay subcontractors next to Box 7
- Setup subcontractors as 1099 vendors
- Double-click on vendor, select Additional Info tab, check box next to Vendor eligible for 1099
- Manage reporting process
- Vendors > Print 1099's/1096
In the end, how to classify your workers is a business decision that only you can make.Â You may save money upfront by classifying them as independent contractors, but you could end up paying much more in the long run if they are reclassified.Â Protect yourself as much as possible with a paper trail - contracts, agreements, written answers to the questions listed above.Â You might evenÂ consider requiring your independent contractors to prove you with documentation that they are actually operating a small business themselves, such as a business license, Doing Business As (DBA) or Tax ID number from the IRS.
If you need additional assistance, please call our QuickBooks technical support line at 888-351-5285. We are here to help you get the most out of QuickBooks!