Mistakenly classifying an employee as an Independent Contractor can result in a significant
back tax bill and heavy fines. Over the past few years the IRS has aggressively been pursuing employers who misclassify their workers.
Central to an IRS investigation into the classification of a worker is how much "control" an employer exerts over its workers. The control an employer has over a worker can be broken down into three areas:
Behavioral Control - factors pertaining to job instructions, training, etc.
Financial Control - factors pertaining to investment expenses, profit/loss, etc.
Relationship of the Parties - factors that cover employee benefits, written contracts, etc.
When evaluating these areas, the IRS uses twenty different factors to determine the relationship between the employer and worker and the amount of control that is exerted by the employer over the worker.
In this article we highlight five questions from the list of twenty, the IRS will consider when determining the appropriate classification of a worker. To obtain a complete list of the twenty questions, you may go here to obtain a complimentary copy.
1. Profit or Loss
Can the worker make a profit or suffer a loss as a result of the work , aside from earned from the project? This falls under financial control and for the Independent Contractor there should involve real economic risk-not just the risk of getting paid. The IRS wants to determine whether the contractor is undertaking a financial risk, where they cannot only make money but run the risk of loosing money.
If the contractor is never at risk of loosing capital and is rewarded with set wages or hourly pay, then the IRS will tend to view that as an employee/employer relationship. if on the other hand, the contractor has to purchase material, pay out wages out of his or her own pocket and runs the risk of loosing money, then it favors the Independent Contractor model.
2. Works for More than One Firm
Does the worker work for more than one company at a time? This can indicate Independent Contractor status but not conclusively. Employees often times work multiple jobs, working at multiple companies. In fact today it is not uncommon for a person to work for 2-3 different employers as a W2 employee.
A good example of an independent Contractor is a freelance writer. If a freelance writer is working for multiple companies at a time, and setting his or her own schedule for working on various projects, it is a strong indicator he or she is an Independent Contractor. On the other hand if the freelance writer is only doing work for one company and has set hours, then that indciates an employer/employee relationship.
Instructions
Do you have the right to give the worker instructions about when, where and how to work? Any of these factors demonstrates to the IRS behavioral control over the worker.
Consider a plumbing contractor; a general contrator will let the plumber know when a site is ready for him, but will not instruct him on how to do the work, or what hours the plumber has to work. He will provide him or her with a deadline and it is up to the plumber to meet the agreed upon deadline.
Full Time Work
Must the worker spend all of his or her time on the job? independent Contractors choose when and where they will work. if you are directing an employee that he or she must maintain a full time schedule to be employed, it is a strong indicator to the IRS that it is an employee/employer relationship.
Right to Fire
Can you terminate the worker? n Independent Contractor cannot be fired without subjecting you to the risk of a breach of contract lawsuit. This goes to the relationsship of the party where it is governed by a contract.
Fortunately for may employers that have been using 1099 contractors, the IRS does have a voluntary Classification Settlement program. You can read about the VCSP here.
To further assist you we put together a list of the top twenty questions the IRS will ask to determine whther the worker is atruly a 1099 contractor or employee. If you have been or thinking of using 10999 contractors you will want to download this list.
The deadline for issuing W2s and 1099s is fast approaching. If you have not sent out your
W2s or 1099s you will have to act quickly. The deadline is January 31.
If you miss the deadline the IRS can levy fines per missing or incorrect W2 or 1099. These fines can add up and be substantial. In the table below we list the fines.
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Penalty Tiers
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If Return is Corrected:
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Penalty Per Incorrect Information Return
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Maximum Per Year
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Small Business Maximum
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First Tier
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Within 30 days from due date
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$30
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$250,000
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$75,000
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Second Tier
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From 31 days up to and including August 1
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$60
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$500,000
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$200.000
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Third Tier
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After August 1
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$100
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$1,500,000
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$500,000
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Note: A qualified small business is one where the average gross receipts are less than $5 million or less for the three most recent taxable years.
As you can see from the table above, incorrect informational returns or not sending out any informational returns to your employees or independent contractors will cost you money.
Who must send out W2s?
All employers are required to send out a W2 to each and every employee that worked during the year.
Who Must Send Out 1099s-Misc?
If you are a trade or business you must send out and file a 1099-Misc for each person you have paid more than $600 to for:
- Rents
- Services
- Prizes and awards,
- Other income payments
- Medical and healthcare payments
- Crop insurance proceeds
- Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the trade or business of catching fish
- Cash paid from a notional principal contract to an individual, partnership, or estate
- Gross proceeds to an Attorney
- Any fishing boat proceeds
- Gross proceeds of $600 or more paid to an attorney
Typically you do not have to issue a 1099-Misc to:
- Corporations
- Payments for merchandise, telegrams, telephone, freight and storage
- Business travel allowances paid to employees (it may be reportable on the employees W2)
However, you should always check with a CPA to help you understand when a 1099 is required or to send out 1099s for you.
Inconsequential Verses Consequential Errors
Businesses can make inconsequential errors and no be penalized. Inconsequential errors are errors that do not delay or prevent the IRS from matching up an informational return with a taxpayer. If you make an inconsequential error The IRS will not assess you a penalty. An example of an inconsequential return might be the misspelling of the first name or address.
Examples of errors that are never inconsequential include mistakes in the surname, incorrect Social Security or taxpayer identification number, wage and tax amounts.
If you make any consequential errors such as the ones listed above, you should send out corrected W2s or 1099s immediately.
The de minimis rule may help you avoid a penalty.
The de minimis rule allows a business to make a small number of mistakes (even with consequential errors) and still not be penalized.
To avoid the penalty with the de minimis rule, the informational returns had to be 1.) timely filed and 2.) the information corrected before August 1 of the filing year. The number of informational returns with mistakes cannot exceed the greater of either 1.) ten in number or 2.) 0.5% of the total returns you are required to file.
The value of up to 10 incorrect informational returns is for small businesses that send out fewer than 200 informational returns. The 0.5% value applies to businesses that send out more than 200 informational returns. For example an employer that sends out 500 informational returns can have up to 25 informational returns that are incorrect (0.5% multiplied by 500 informational returns).
Key to Compliance
The key to compliance is to gather the correct information when you have the most leverage. For employers this is at the time they hire an employee. For a business engaging the services of a contractor it is before you make any payments to them. If your payment to them is contingent on them submitting a properly filled out W9, they will be motivated to get you the completed W9.
Most businesses do not have an issue with obtaining and including the correct information on W2s for employee. When an employee is hired, the employee's name, Social Security number and address, can be easily verified. In NC and in many other states, businesses are obligated to or will be obligated to use the E Verify System. See our article regarding the E Verify requirements or download our E Verify Guide. if you need assiatnce with sending out W2s you can contact a payroll company to assist you.
What is more challenging is issuing 1099s. Based on our experience working with business owners, businesses do not always collect the contractor's information (correct name, taxpayer Identification number, address, etc.) up front. Not having the W9 on file requires them to chase down the contractor at the end of the year and collect the required information. This delays the process. In some cases the contractor cannot be found or does not provide the information required, preventing the business from issuing a 1099 altogether.
The IRS takes the deadline for sending out correct W2 and 1099 informational returns seriously. Fines can add up quickly and jeopardize the financial well being of a business. if you have difficulty or need assistance, it is better to contact a professional that can assist you rather than wait and be fined by the IRS.
From the HR Pros at Richard A. Beauchemin, CPA /
Carolina Accounting & Tax Services, PLLC
In pursuit of employers who misclassify their workers, the U.S. Department of Labor (DOL) has been aggressively ramping up the number of investigations and its employment law enforcement efforts. We highlighted that in a previous post, which can be found here.
In alignment, the Internal revenue Service (IRS) announced its Voluntary Classification Settlement Program (VCSP), which may offer relief for employers from unpaid employment taxes, penalties, and interest resulting from worker misclassifications. To determine whether or not joining the VCSP would be a smart move, an employer needs to consider some key factors.
Under the VCSP, an employer may voluntarily reclassify their workers as employees for future tax periods for employment tax purposes. To participate in the program, the employer must meet specific eligibility requirements, apply for the VCSP, and enter an agreement with the IRS. An employer may be considered eligible for the program if it:
- Is not subject to a worker misclassification audit currently engaged by a federal or state agency.
- Has consistently treated the workers in question not as employees (i.e., as independent contractors).
- Has filed for the past three years the required Form 1099s regarding the workers.
If the IRS approves the employer's eligibility and participation into the VCSP, then the employer must establish a "closing agreement" with the IRS. The agreement's provisions include, but are not limited to:
- A three-year extension of the statute of limitations for collection of employer back taxes during the first three years upon participating in the program.
- A limit of 10 percent of the employer's employment tax liability that may have been owed on compensation paid to the workers for the most recent tax year, without interest and penalties.
- No audit for employment tax purposes for prior years with respect to the classification of the workers in question.
- Treatment of the identified workers as employees moving forward.
While the VCSP appears attractive at face value, other factors require employers like you to recognize potential risks and, if deciding to participate in the program, to proceed with caution:
- First of all, the IRS is not obligated to accept an employer's application (IRS Form 8952) to the program. So, if an application is rejected, the employer may have in essence, admitted to worker misclassification fault, thus creating a potential case for wage and hour lawsuit claims.
- The IRS relief does not apply to other federal or state agencies (i.e., the DOL) which have similar responsibilities for worker classification compliance enforcement. As established through recent "memorandums of understanding" with participating agencies, IRS information-sharing would likely increase exposure of an employer's liabilities related to worker misclassifications.
- The employer must account for and remedy any previously avoided expenses (i.e., due to failure of complying with minimum wage and overtime laws, of providing company-sponsored employees benefits, of offering workers' compensation and unemployment insurance, etc.).
As more details from the IRS regarding this newly-developed VCSP emerge, employers are encouraged to conduct preliminary research and internal assessment focused on the nature and degree of any worker misclassification issues. Review applicable state and federal classification standards, conduct a company-wide worker classification audit and stay on top of relevant IRS notifications and employment law updates.
Of course, the best course of action, when hiring a new worker, is to classify them properly and place them on your payroll immediately, if they are employees.
Are you thinking of giving away prizes, or coupons as prizes,that have a total cash value of more than $600, to any single individuals?
If so, beware, you will have to send out a 1099 to any indvidual that you give more than $600 to in prizes including coupons that have a cash equivalent value of more than $600.
- Have you won a prize or coupons that have a cash value of more than $600 from a single source?
If so, you may receive a 1099 on that prize or those coupons.
Last year, Bob Choate, a Houston resident learned this lesson the hard way. While attending a Houston Astro's game, he won a year's supply of coupons for free coffee, and a donut, or 1/2 dozen donut holes.
Earlier this year, as the winner of a year's supply of calorie busting coupons, he received a 1099 showing that he owed taxes on $927.61 of income. This was the cash value of the coupons for the free donuts and coffee for a year.
The Federal tax code states that prizes, awards and yes coupons as prizes, be declared as taxable income. A 1099 must be issued to any individual you give a prize to whose winning exceeds $600, and that individual must declare those winnings on his or her personal tax return.
Of course, if you do win a years supply of coupons and the cash value does exceed $600, you do have the option of declining the prize.
If you would like to give away prizes, or coupons as prizes, and you do not want to send out 1099s, you can keep the total cash value that any single individual is allowed to win to less than $600.
If you are a business owner and want to promote your business by giving away coupons, gift cards or free services, you may want to consider keeping "the fair market value" of prizes to any single individual below the $600 threshold.
Taxed income, especially unplanned taxed income, can cause negative reactions. Rightly or wrongly, your prize will be linked to taxes and most likely a negative response from the recipient. Probably not the response you would like to receive from prize winners.
If you are a business owner and have questions about prizes or 1099s contact us we can assist.
Businesses scored a big win yesterday as the Senate voted to repeal the 1099 reporting requirements that was part of the Healthcare bill. This requirement had been the topic of several blog articles that can be found here, here, here and here. In these blog articles, we highlighted the devastating impact and high costs that this requirement would have had on businesses. Fortunately, both parties realized this was a burdensome reporting requirements.
This provision was slipped into the Healthcare bill and required that businesses would have had to report all business transactions with any single person or business that totaled more than $600 in a calendar year. According to Kenneth Schortgen, JR in his article that appeared on examiner.com today, he highlights the cost to businesses: "The sheer cost of doing this, coupled with the cost many people would have incurred by hiring accounting help just to deal with this provision, could have burdened small businesses to the point that up to 40% would have had to close their doors, or layoff workers."
The bill must still pass the House and be signed into law. Few problems are anticpated with it passing the House and President Obama during the State of the Union address indicted hew was willing to compromise on the 1099 reporting requirement.
As lawmakers embark on their lame duck session, CPA firms, business owners and corporations are hopeful that Congress and the President are sincere in their desire to repeal the onerous, 1099 reporting requirements that was attached to the Healthcare reform legislation passed last March.
We have posted several articles that can be found here, here and here about this issue. In short, all consultants, sole proprietors, partnerships, S corporations, C corporations and farming businesses, will have to issue a 1099 for any vendor or individualthat they sepnd more than $600 with.
According to a Taxpayer Advocate Service (TAS) analysis of 2009 IRS data, about 40 million businesses and other entities will be subject to this new reporting requirement. It would require a painter to issue a 1099 to Home Depot or Lowes, if he or she spends more than $600 on supplies with them for the year. This would be true for landscapper, to issue a 1099 to the gas station, he purchases gasoline from, or the consultant who spends more than $600 with Office Depot on office supplies.
If each business entity has to issue, on average, just twenty-five 1099s each year, more than 1 billion 1099s would be issued annually. A volume that would seem difficult for the IRS to even be capable of handling.
Max Baucus (D-Mont), Chairman of the Senate Finance Committee has stated that he would introduce legislation to repeal the expanded 1099 reporting requirments, that will start in 2012
In an article published by CNNMoney.com, Max Baucus is quoted: "I have heard small businesses loud and clear and I am responding to their concerns ," Baucus said in a prepared statement. "Small businesses are the backbone of our economy in my home state and across the country, and they need to focus on creating good-paying jobs -- not filing paperwork."
In addition to the new reporting requirements, the fines and penalties for incorrect and late filings of 1099s, w2s and other information returns, has also increased significantly.
If this reporting requirement stands, CPA firms envision, a major increase in work volume and increased cost, for the business owner, in order to stay compliant with this burdensome and onerous piece of legislation.
Congress has returned from its August and recess and wasted no time getting down to business. Yesterday, the Senate cleared a hurdle to pass It's Mini-Tarp, aka the Small Business Bill. After the cloture vote passed, the Republicans could not stop it. They then turned their attention to amendments to the bill.
One issue they tried to tackle was to to ease the 1099 requirement that was passed in the Health Care bill. We posted here, here, here and here regarding the 1099 issue and how onerous this will be to all businesses in every industry and every size. Businesses from sole proprietorships to large corporations will be impacted with the additional cost and time required to track every business they sepnd more than $600 per year with and send out a 1099 to each of these businesses. For many business this could mean sending out hundreds to thousands of additional 1099s per year. Unfortunately, both the proposed amendments to correct this issue failed.
For now, starting in 2012, all of your expenditures with any one vendor that total more than $600 will have to be issued a 1099. Although, I would expect over the next year we will see additional efforts to eliminate or modify this requirement. Both parties recognize, how this is a bad idea and was a bad piece of legislation that was allowed to pass.
Last week Heather M. Rotham published an article Congress Urged to Scrap New Form 1099 Reporting Requirements, in whcih she outlines why it is not a given that new 1099 reporting requirements will go into effect. Previously we did a post here and here on the new 1099 reporting requiremnts.
In her article, Heather outlines the action the US Chamber of Commerce has undertaken to have this piece of legislation reversed.
The U.S. Chamber of Commerce announced Aug. 17 that more than 1,099 companies around the nation have signed a letter to lawmakers asking them to repeal new Form 1099 reporting requirements, calling them burdensome, complex, and very costly.
She also nincludes some of the content of the letter from the U.S. Chamber of Commerce regarding issues we highlighted here and here.
"If this provision is implemented, the 1099 reporting mandate will impose substantial paperwork and reporting burdens on the backs of governments, nonprofits, and businesses-especially small businesses," the companies wrote. "This provision will also serve to dramatically increase accounting costs, expose businesses to costly and unjustified audits by the [Internal revenue Service}, and subject more small businesses to the challenges of electronic filing."
Currently there are at least two proposal for changing the new 1099 reporting requirements. Once lawmakers return from the August recess they will consider changes to the recently passed 1099 reporting requirements as part of H.R. 5297, a small business bill
Over the past year we have had massive new legislation and spending bills passed. Everything from, health care reform, to an extensive financial reform package and massive spending bills have been passed. Every bill passed includes changes to the tax codes and imposes new laws. Whenever something is passed there is a projection of how the new law will work and its impact on revenue and expected costs.
For example, in a previous post, that can be found, here we highlighted the change to reporting requirements for issuing 1099s. Essentially, anytime someone spends more than $600 in business income, with any person, partnership or corporation, they will have to issue a 1099. The reasoning behind this was to generate additional tax revenue to help fund the recently passed healthcare bill. It is believed, by the IRS and other government officials, that many businesses are under-reporting business income. This provision, included in the new law, would help track almost all business income. However, it is currently receiving blow-back from the business community because of the additional record keeping requirements and cost of issuing significantly more 1099s.
A glaring and current example of how a law can have unintended consequences is playing itself out in the UK. The HM Revenue and Custom's Agency (UK's equivalent to the IRS) won a high profile case against Andre Agassi four years ago. It allowed the agency to go after the "passive income" not necessarily generated in the UK. For example if an athlete, movie star, etc. has an endorsement deal, and they participate in an activity in the UK, the UK can tax the endorsement income according to the percentage of time spent in the UK participating in that activity.
If an athlete has a $10M endorsement deal and participates in 10 events worldwide with one of those activities is in the UK, they will tax one-tenth of the endorsement income at the 50% tax rate. In this case, the athlete would owe $500,000 in taxes for the opportunity to participate in that one event in the UK (10% of $10M taxed at a 50% tax rate).
The Independent, posted an article found here, describes how this tax may keep Tiger Woods away from playing in the Ryder Cup this year, along with other athletes. It also highlights how global organizers of major events are reconsidering the UK, as a country to host International sporting events, while this tax is in place.
Mitchell Platts, the European Tour's director of public relations corporate affairs, yesterday revealed the anger and frustration in British golf. "These tax rules are discouraging leading sportsmen and sportswomen from competing in Britain," he said, "Our aim is to attract the best players to provide the best entertainment for our audiences in the UK. This tax rule is seriously hampering our efforts."
It is estimated that if Tiger Woods were to play in the Ryder Cup (a tournament which pays no prize money) it could cost him over 900,000 pounds. The article describes how this tax impacts those with endorsement deals.
"product endorsements that are directly connected to the sportsperson's performance are subject to UK tax," explained an HMRC spokesperson. Though full UK expense arising from the performance can be claimed against income chargeable to UK tax."
Woods deal with Nike is rumored to pay $40M a year. So if he played 14 events this year, and one of those is the Ryder Cup, he would be billed to pay tax at 50 percent, on one fourteenth of that amount, leaving the potential tax bill as high as 900,000 pounds."
The article further highlights how this tax is impacting other athletes and sporting events.
Already Roger Federer prefers to play his Wimbledon warm-up event in Germany rather than at the Queen's Club.
For marathon runners, who compete in few races each yaer, the implications are starker still. If they run two races, one of them in London, half of their total endorsements would be taxable here.
The UK is currently the only nation in Europe that taxes endorsement income. Wembley stadium lost out on its bid to host the 2010 Champions' League final after failing to provide assurances that players would not be taxed. A special waiver was introduced in march to help prevent Wembley from losing the 2011 final.
In golf Sergio Garcia has revealed he limits UK appearances due to tax. After playing in the Scottish Open last month, the Spaniard would have had to finish in the top three at next week's Open just to break even.
Whether it's passing a 2,000 plus page bill without knowing all the details, or a revenue agency winning a court case, there are always unintended consequences. As we see in the UK, athletes and International sports organizers simply choose to not participate or minimize their appearances in the UK, thus minimizing their exposure to large punitive taxes.
If the HMRC had assumed that there would be a negligible affect on the appearance of athletes at major events in the UK in their revenue projections, then they miscalculated. The number of famous athletes choosing not to participate in major events in the UK, not only reduces the tax collection from the projected revenue stream, but also harms the local economy and total taxes collected. Fewer high profile athletes and major events means far fewer tourists and fewer dollars for local business owners. The net result is fewer taxes collected as a result of decreased tourism and advertising dollars spent, not to mention a loss of television revenue.
The bottom line is that when legislation is passed, or large taxes are imposed, individuals and businesses will simply adjust their plans or habits to minimize the impact on them. In addition to the HMRC policies in the UK that highlight this behavior, we see other examples, everyday in the US. Individuals and businesses are constantly moving from one highly taxed state to a state with a lower tax burden. Even politicians that favor tax increases are not immune to this behavior. Recently, Senator John Kerry from Massachusetts, chose to dock his yacht in RI rather than his home state of MA. Docking the boat in RI saves about $500K in sales and excise tax. After being called out, he agreed to pay Massachusetts the taxes.
Needless to say, after a new policy or law is passed, individuals and businesses adjust their behavior to the new regulations so as to minimize the impact the policy will have on them or their business. What politicians and policy makers do not understand or foresee are the changes in behavior of individuals and businesses, as a result of policy decisions and new laws thus leading to unintended consequences.
In a previous post Welcome to Healthcare Tax Compliance Hell, a little known clause that was slipped into the Health Care legislation, was highlighted. This clause required that any taxpayer, with business income, is required to issue a 1099 form to any, and all vendors that they purchase goods or services from, and spend more than $600 per year with.
As highlighted previously, this means that when a painter or contractor goes to Home Depot or Lowes and purchases goods that total more than $600 in a year, they must issue Lowes or Home Depot a 1099. This is applicable to all individuals that generate business income regardless of how small they are.
The IRS is starting to come to grips with how extensive and onerous this new law is for individual taxpayers, small business owners and large businesses.
As always there are unintended consequences when laws such as this are implemented. One significant unintended consequence is that a number of companies may scale back on the number of vendors they use in order to minimize the number of vendors they have to track and issue 1099s to.
Neil deMause, in an article posted on CNN money.com, IRS Starts Mopping up Congress's tax reporting mess, highlights information from a report released by National Taxpayer Advocate Nina Olson.
An estimated 40 million taxpayers will be subject to the requirement, including 26 million who run sole proprietorships.
The article goes onto comment how Nina Olson is concerned with the new requirement.
Like may who have delved into the new rules, Olson is concerned about the far-reaching scope and potential unintended consequences.
"The new reporting burden, particularly as it falls on small businesses, may turn out to be disproportionate with any resulting improvement in tax compliance," the taxpayer advocate wrote in a report released this week.
The intent of the law is to create a paper trail for all business transactions. However, the massive burden and requirements for small business owners to comply may outweigh the benefits. In the CNNMoney article, they highlight how Pennsylvania business networking organization, SMC Business Councils, surveyed its members and found the requirement for issuing 1099s will increase on average from 10 to over 200.
In a previous post, Does Your Business Accept Credit Cards, If so, be Aware of What Awaits You in 2011, we highlighted how starting in 2011, credit card companies will be required to issue merchants a 1099. The purpose is so the IRS can track income to a business from credit card sales. This was a little known provision slipped into the Housing Assistance Tax Act of 2008.
IRS commissioner, Douglas Shulman, announced in May that credit card and debit card transactions to vendors would be exempt from this new 1099 reporting requirement. The reason, being is that the IRS will be capable to track the information based on the 1099s issued from the credit card companies.
This could be a a big boost to credit card processing companies, as more companies may use debit or credit cards in an effort to minimize the 1099s required to be issued. However, it could also drive up costs, since credit card processing fees are typically 2%-3%. of the purchase price. At some point in time, these costs will be passed on, in the form of higher prices.
In addition, it would also be likely that a number of business that use a number of different vendors, would try and consolidate to fewer vendors in order to reduce the reporting requirements. Finally, this law promises to drive up administrative and record keeping costs for businesses in order for the businesses to comply with the new regulations and filing requirements.
All of these new reporting requirements are all about tracking revenue and identifying businesses that are underreporting income. With the issuance of 1099s by the credit card companies, and taxpayers who generate business income, the IRS can cross reference the 1099 payments to reported business income listed on the year-end tax return for that business. If there is a disparity between the 1099s issued to that business and the reported income on the tax return, the return could be flagged.