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Distinguishing between Independent Contractors or Employees; Don’t Let Mislabeling Cost You

Employers have several tax obligations related to their employees. They are expected to withhold income taxes and social security and Medicare taxes from their employees’ pay in addition to paying unemployment tax on their wages. On the other hand, employers have no tax obligations on payments they make to independent contractors. Whether or not you use the services of independent contractors or employees depends entirely upon your business needs, but it is critical that you know the difference between these two very different types of workers.

Employers have several tax obligations related to their employees. They are expected to withhold income taxes and social security and Medicare taxes from their employees’ pay in addition to paying unemployment tax on their wages. On the other hand, employers have no tax obligations on payments they make to independent contractors. Whether or not you use the services of independent contractors or employees depends entirely upon your business needs, but it is critical that you know the difference between these two very different types of workers.

Basically, under common law rule, an independent contractor is someone who provides service to your business and whose method of working you cannot control. You only have the right to control or direct the result of his or her work. According to the IRS, you are working with an independent contractor when you cannot control “what will be done and how it will be done.” Anyone who performs a service for your business is an employee, if you can control what will be done and how it will be done.

With the many different kinds of trades, services, and business arrangements available across the many industries in our market, there are some workers who just do not seem to fit perfectly into any one category of either employee or independent contractor.

To complicate the matter even further, certain kinds of independent contractors may also be considered statutory employees for tax purposes. An example of this kind of service provider is a life insurance sales agent who works full-time and who chooses to sell life insurance or annuity contracts for one particular life insurance company. In the same vein, certain workers may be considered statutory non-employees.

 

Determining the Type of Individuals Performing Services:

Independent Contractor – A self-employed individual who performs a service or creates a product for a business, but the business cannot control or direct how the work is done is an independent contractor. Typically doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers and auctioneers fall into this category.

 

Employee (common-law employee) –Anyone who performs services for a business by controlling what will be done and how it will be done.

 

Statutory Employee – Even if workers are independent contractors under the common law rules, such workers may still be treated as employees by statute for certain employment tax purposes.  If they fall under one of four scenarios and meet three conditions under the Social Security and Medicare taxes, then you may still need to treat them as an employee for tax purposes.

  • Drivers distributing beverages (other than milk) or meat, vegetables, fruit, or bakery products; or who pick up or deliver laundry or dry cleaning, if the driver is your agent or is paid on commission.
  • A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
  • An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
  • A full-time traveling or city salesperson that works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the byer’s business operation. The work performed for you must be the salesperson’s principal business activity.

 

Social Security and Medicare Taxes

Employers should withhold Social Security and Medicare taxes from the wages of a statutory employee if all three of the following conditions apply:

  1. The service contract states or implies that substantially all the services are to be performed personally by them.
  2. They do not have a substantial investment in the equipment and property used to perform the services.
  3. The services are performed on a continuing basis for the same payer.

 

Statutory Nonemployee: Believe it or not, there are three categories of statutory nonemployees, too: direct sellers, licensed real estate agents and certain companion sitters.  The first two categories, direct sellers and licensed real estate agents are treated as self-employed for all federal tax purposes including income and employment taxes, if:

  • Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
  • Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.

 

Conversely, companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed for all federal tax purposes.

 

Government Worker: In most cases, individuals who serve as public officials are government employees.  In this situation, the individual is an employee of the government and the government entity is responsible for withholding and paying Federal income tax, social security, and Medicare taxes.

 

Still confused?

There are generally three common law categories that can be used to help you distinguish the type of business relationship you have with your worker and whether or not he or she is an independent contractor or an employee. They are behavioral, financial, and type of relationship – and they highlight the levels of control and independence in the business relationship.

Behavioral – Consider whether you have the right to control what your worker does and how he or she gets the job done.

Financial – Do you control all the business aspects of the job, such as supplying tools and materials, or deciding how the worker is paid, and whether or not expenses are reimbursed?

Type of relationship – Are there written contracts or benefits established, such as a pension plan, leave pay, or insurance? Is it an ongoing relationship that facilitates a key service to the business?

While the IRS provides extensive guidance on determining a worker’s status, there is no strict black and white, easy-delineation; you are encouraged to look at the entire business relationship to come to an understanding. If after you have looked into the situation thoroughly and you still have doubts, you can get help from the IRS by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will look over the data and officially identify the worker’s status for you.

If you’re still unsure, it may be time to solicit the assistance of a small business advisor. Visit the Find an Accountant tab to locate a small business accountant, enrolled agent or tax advisor near you.

PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants, Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations.

 

To find a trusted accountant in your area, visit www.SmallBizAccountants.com.

 

Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice. Any information contained in this article does not fall under the guidelines of IRS Circular 230.

Paying Yourself When Starting a Business

Determining how to pull money from your business is a critical step in small business ownership. Whether you take a draw or a salary, makes little difference if you are a sole proprietor. A combination of salary and draw is typically how most small businesses start. When the business is doing well, the draw can be easy to utilize, but remember that the business will need cash flow when times are leaner, so overdrawing on the business can cause issues down the road.  That’s where a controlled salary can help keep cash in the business and make it less tempting to take more cash out of the business than you really need. The owner’s draw is also taxable on the owner’s personal tax return and  owners must make estimated tax payments and self-employment taxes on any draws.

Your business type is critical.

If you are a sole proprietorship, you can take whatever amount you’d like for compensation, if the business has any money. If however, you use any other business type, the issue of compensation becomes much more complicated. If you have an S-corporation or a C-corporation, there are IRS rules regarding compensation and stock options that you need to be aware of and know the ins and outs of using. This is a great time to talk with a tax accountant about the differences and how to stay in compliance with all of the rules surrounding executive compensation limits.

 

To fully understand the salary versus draw decision, you must understand owner’s equity. When starting a business, the business owner contributes cash, equipment and other assets into the business.  Asset contributions elicit owner’s equity in the business. Accountants define equity in a simple formula:

Assets – liabilities = equity

Assets used in business include cash, equipment and inventory. Liabilities are the monies the business owes and includes bills that must be paid each month. If a business was to convert all of the company’s assets into cash and then used that cash to pay off any liabilities, any remaining dollars are considered the business’ equity. Calculating the business’ equity is a good way to determine the actual value of the business and then make a decision regarding taking a draw.

One-Third Rule

In order for your business to thrive, it’s important to remember that taking all of the profits out of the business in the form of a salary or a draw, will leave nothing for future growth or leaner times.  With that in mind, consider the one-third rule.  Take one-third of the business’ gross income and place it in a money market or business account. Take the second third of the income and use it to pay business expenses. The final third can be used to take personally or put back into the business for additional capital expenditures or growth.  This model won’t work for every business type, as businesses with greater capital outlay such as retail businesses have a much tighter margin than service related companies with smaller expenses.

Set your budgets – even in the beginning.

Get what you need to keep yourself and your family afloat. One of the leading causes of divorce is financial hardship. Bear that in mind when you go to your spouse and ask to strap the family for not just a short while, but for what could realistically turn into years. Also consider that if you carry the health insurance benefits through your salaried position now that either your spouse will need to pick up coverage, or you will have to seek other options. Sole proprietors, members of LLCs, and partners must each pay self-employment taxes on draws and any other distributions taken from the business.  S Corp shareholders do no pay self-employment taxes on distributions, but each owner who works as an employee of the company must be paid a ‘reasonable compensation’ before profits are paid.  Those employees will then pay taxes on the monies paid

 

Taxes, Man, Taxes.

Remember that no matter what kind of business entity you decide to create, Uncle Sam will always want his cut including Social Security and Medicare taxes (FICA).

Ultimately, the choice is yours, but before taking a draw or salary consider the following:

  • Business funding – Does the business have enough capital to operate sufficiently before you take the draw?
  • Taxes – Understanding tax liabilities, both for the business and personally is crucial to deciding whether to take a draw or a salary and through which type of business entity. There is no method that escapes the tax bill, so plan now for future draws and income.
  • Plan – Talk with a business tax specialist about the best ways to handle tax payments and individual liability based on your business type.

 

To learn more about tax planning and your small business, talk with a Professional Small Business Advisor by clicking Find an Accountant on this page.

 

PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants, Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations.

The Inside Scoop on Donor Advised Funds

Looking for a different way to donate to your favorite charity? Many investors are finding that donor advised funds are a creative way to contribute dollars while still receiving a tax deduction for their efforts.  The Donor Advised Fund (DAF) is a charitable vehicle created at a public 501(c)3 organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors who receive an immediate tax benefit while recommending grants from the fund to charities of their choice over time.  Instead of making a one-time contribution to your favorite charity, contributors of donor advised funds can either set up their own private fund or use an established DAF and then direct how the contributions are distributed.

 

A Little DAF History

Donor advised funds aren’t new; rather they originated in the 1930’s.  It wasn’t until 1969 that congress established a legal structure for them.  Thirty years later, DAFs took off increasing in popularity and today the funds account for “more than 3 percent of all charitable giving in the United States.” In fact, Fidelity Investment’s Charitable Gift Fund surpassed the United Way as the largest recipient of charitable funds in the country. According to author Helene Olin in Atlantic Monthly, “Donors put $23.27 billion in Donor Advised Funds in 2016, a 7 percent increase since 2015 and 18 percent since 2014.”

How it works:

  1. Contributions are placed into the fund.
  2. Immediate tax deductions are received by the taxpayer for the amount they have ‘donated’ into the fund.
  3. Administration of the DAF including investments (in the stock market) is ongoing.
  4. Either immediately or at some point in the future, the taxpayer makes grants to qualified charities of his/her choice from the fund.

Once the money is in the fund, the dollars cannot be returned to the donor and become the property of the ‘fund’. The underlying issue for nonprofits is the inherent delay between taxpayer donations to the fund and their eventual distribution to the nonprofit.  Appreciative recipient nonprofit organizations argue that because the funds don’t have to be released on any set time horizon, it is very difficult to determine or plan for the contributions. Additionally, because the funds are anonymous, donors can elect to remain in secret making it harder for nonprofits to thank donors and cultivate new supporters. While these are legitimate frustrations for the nonprofits, reports say that donors under age 50 are gravitating more frequently to the Donor Advised Funds. To survive with the next generation of donors, nonprofits are going to have to find a way to work with these funds and find more creative ways to market to donors and receive the funds.

 

 

Who can set up a donor advised fund?

The good news is that donor advised funds are not just for the wealthy. For funds like Charles Schwab’s Charitable fund, anyone can start a fund with as little as $5,000 in irrevocable funds and add additional contributions, if any, of as little as $500. Donors can also control how and when the funds are distributed. Funds can remain in the fund in perpetuity. Unlike charitable foundations, that must by law allocate 5 percent of their dollars annually, DAFs are not bound by the same distribution rules.  For the more affluent investor, supervised, or ‘administered’ funds can be started with a minimum of $250,000 or more and select an individual investment advisor to manage the fund. Of course, administrative and investment fees vary based on the type of account under management.

 

If you have questions about how to start a donor advised fund or financial investment strategies, talk with a PASBA Small Business Advisor.

 

PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants, Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations.

 

To find a trusted accountant in your area, visit www.SmallBizAccountants.com.

 

Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice. Any information contained in this article does not fall under the guidelines of IRS Circular 230.