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.
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.
If Return is Corrected:
Penalty Per Incorrect Information Return
Maximum Per Year
Small Business Maximum
Within 30 days from due date
From 31 days up to and including August 1
After August 1
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:
- 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:
- 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.
With the New Year come changes. Not only do we have renewed commitments to personal goals but there are also changes to business regulations and laws.
Most importantly for business owners and managers there are changes each year to the payroll tax laws. Here are four of the top changes for 2013.
1. New W2 Health Benefits Reporting Requirements
Beginning with the W2s, that are being sent out now, for the 2012 reporting year the Patient Protection and Affordable Care Act requires that if you provide employee health care coverage, the cost of the employee coverage must be reported on the employees' W-2 form.
This does not mean that the health care coverage benefit is taxable only, that is required to be included on the W2s. The reporting is for informational purposes. It provides the employees with information on the total cost of their health care cost while also providing the IRS with information for tracking employee coverage.
The IRS has been tasked with enforcing the individual mandate for health care coverage in the Patient Protection and Affordable Care Act. Tax filers will have to begin including the amount paid for health care coverage on their tax return to show proof of health care insurance. The IRS can cross reference the information on the tax filers 1040 against the employer provided information on the W-2 form. This will allow the IRS to more easily track and verify coverage.
Employers that provide "applicable employer-sponsored coverage" under a group pan are subject to this reporting requirement. Businesses, tax-exempt organizations, and federal, state and local government entities are all included in this requirement. The exceptions to this are plans maintained for the military and family members of the military and federally recognized Indian Tribes.
If an employer is not required to issue a W-2 form such as to retirees or other former employees, they will not be required to issue a W-2 solely to report health care coverage cost.
Currently, for employers that issue fewer than 250 W2s, this reporting requirement is optional. However, as with many tax laws and regulations, it is subject to change.
2. Social Security Tax Increase
For 2011 and 2012 employees enjoyed a 2% reduction in their Social Security tax. For both of those years, employees paid 4.2% in Social Security tax. This tax reduction was not retained as part of the fiscal cliff deal and instead allowed to expire. For 2013 and going forward the Social Security tax for employees will be 6.2%.
3. Social security Limit Change
For 2013 the amount of income subject to Social Security tax is $113,700. This is up from $110,100 in 2012. For Medicare tax there is no income limit on what is subject to the 1.45% of Medicare tax.
4. New Medicare Tax
Beginning in 2013, all wage earners will be subject to an additional 0.9% Medicare tax when their wages exceed $200,000. This is regardless of whether they are a single or joint filer. Once their wages exceed $200,000, the total Medicare tax will be 3.35% (the 1.45% plus the additional 0.9% surtax on the income over $200,000). The Medicare surcharge tax was part of the Patient Protection and Affordable Care Act.
Tax laws and payroll reporting requirements are becoming increasingly complex. Not only do employers need to know what to report and record on W2s they need to know how to correctly code the information and whether it a taxable item to the employee.
Incorrect information on the W2s can result in penalties per incorrect or missing W2. Penalties start at $30 per incorrect W2 if the information is not corrected within 30 days from the due date. They increase up to $100 per incorrect W2 if not corrected before August 1 of the filing year. Total penalties for a company can be as high as $250,000 for if the W2s are not corrected within 30 days of the due date. If the W2s are not corrected or issued until after August 1 the penalties can reach as high as $1.5 million for the company.
For more information about payroll taxes, download our 2013 Payroll Tax Guide Summary.
Are you an owner of an S Corporation? If so, you may want to do a salary checkup and make sure your salary is reasonable and customary. Ealier this year the Eighth Circuit Court upheld a lower court's decision regarding the salary of the owner of an S Corporation.
In 2002 and 2003 the owner of the S Corporation paid himself a salary of $24,000 while taking distributions of $230,651 and $175,470 respectively. Based on an expert witness hired by the IRS, the IRS argued that the owner's salary was unreasonably low and that a reasonable salary for this owner was $91,044.
The benefit to an owner of an S corporation, for taking compensation as distributions rather than as W2 wages, is that they save themselves the Federal Insurance Contributions Act (FICA) taxes commonly known as Social Security and Medicare taxes.
The IRS argued the owner was underpaying himself by $67,044. Accordingly, based on the IRS' argument, these are wages that should have been subject to Social Security Taxes and Medicare Taxes.
Back in 2002 and 2003 the Social Security and Medicare taxes for an owner was set at a rate of 15.3% (7.65% owed as the employee and 7.65% owed as the employer). The total tax on the additional $67,044 in wages equals $10,258 per year ($67,044 multiplied by 15.3%). For the two years in question, the total additional Social Security & Medicare tax would have been $16,626.
The Eighth Court affirmed the lower courts decision and based on the owners work experience and knowledge, the $24,000 salary was unreasonably low.
Additional information about the court case and the IRS argument can be found here at the Journal of Accountancy's web site in an article published by Sally Schreiber.
It is important for an S Corporation owner to seek advice from a professional CPA to help him or her determine a reasonable salary for the purpose of payroll wages. If the IRS believes your W2 wages are too low you may be in the unenviable position of trying to defend it to the IRS. If you can't make a legal argument or justify your wages before the IRS (or courts) and the IRS determines they are too low, you will owe additional FICA taxes plus penalties and interest.
All employees should have received a copy of their W2s by the beginning of February. If you have not received yours yet, then you should call your employer and request a copy immediately. By law, employers have until the end of January to mail out copies of W2s to employees. Failure to comply with the W2 filing requirements and deadline can lead to hefty fines and penalties for employers.
Follow the steps below if you have not received your W2 or if you have received an incorrect W2.
- Contact the employer to find out, if and when, it was mailed. If you changed your address, or an incorrect address was listed on the W2, then the W2 may have been returned to the employer as undeliverable. Make arrangements to have it picked up or mailed to the correct address.
- If after a few days, you still have not received it, contact the IRS at 800-829-1040. The IRS will ask for your name, SS number, address and phone number. You will also need to provide them with your employer's name, phone number address, dates of employment and an estimate of your wages for the year. Usually, you can find this information on the last pay stub you received.
- You are still required to file a tax return and report this income before the tax filing deadline (April 18, this year) regardless of whether you received a W2 or have an incorrect W2. The IRS has form 4852, than can be used as a substitute for the W2, but only after you have contacted your employer and the IRS. Fill out form 4852, estimating your income and withholding taxes. You can use your last pay stub for the basis for your wage and income tax withholding estimates.
- After your tax returns has been filed, it is possible you will receive the missing W2 or a corrected W2. If this information is different than the amount listed on form 4852, that was filed with your taxes, you will have to do an amended return to reflect the correct amount listed on the W2.
As a taxpayer, you are responsible for reporting all income to the IRS. Not receiving a W2 is not an valid reason to not report the income. Employers are forced to pay hefty fines and penalties for not sending out W2 information and reporting its employees' wages to the IRS. Eventually, they will report your income. If the IRS cannot match the income you reported on your tax return to what your employer reported to the IRS, you will receive a an IRS notice detailing the additional taxes you owe plus penalties and interest.
Visit our services page to see how we can asssit you with your tax preparation this year.