Why Small Business Owners Must Exercise Care When Classifying Workers

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One of the primary ways small business owners end up in trouble is to avoid the expense and complexities of payroll taxes by classifying workers as independent contractors. Generally speaking, you are responsible for withholding income taxes, withholding and paying Social Security and Medicare taxes and paying unemployment taxes on all wages paid to your employees. Independent contractors, on the other hand, are responsible for paying their own taxes. As the small business owner you are responsible for determining whether your employees are, in fact, “normal” employees or whether they can legitimately be classified as independent contractors.

To correctly determine the classification of each person who works for you, you must first have a good grasp of the type of working relationship shared by yourself as the small business owner and the person supplying services for your business. First ask yourself a few questions regarding the degree of control you exercise over the person in questions. As far as behaviors, does your small business exercise any management regarding how the worker completes his job? Are you in control of how the worker is paid, who provides tools and supplies or whether expenses are reimbursed?

Do you have a written contract with the worker or does he or she receive regular benefits such as those enjoyed by most regular employees such as health insurance, vacation pay and a pension plan? There is no magic formula which will instantly tell you whether your workers are employees or independent contractors therefore you must look at the entire relationship the worker has with you and your small business. If you are unsure, but want to classify a worker as an independent contractor, protect yourself and your business from a future audit by doing the following:

  • Enter into a written contract which clearly spells out responsibilities of both parties and how payment will be determined for each job.
  • Require the independent contractor to provide all tools, equipment and materials needed to complete the job
  • If possible, have the independent contractor perform the majority of the work at his or her own place rather that at your place of business.
  • Have it clearly understood that as an independent contractor, your worker is free to offer his or her services to others.
  • Pay for the work by the job rather than monthly, hourly or weekly pay and insist upon invoices from the independent contractor prior to issuing payment.
  • Ensure your independent contractor has a business license and insurance and ask for proof that the independent contractor is properly reporting to the IRS what you pay.

Never simply cross your fingers and hope you will never be audited so you can avoid the hassle and expense of having employees on a regular payroll. This is the number one way small business owners get into trouble, and the number one thing the IRS looks closely at. If you have any doubts about whether your workers are regular employees or independent contractors, seek the advice of an experienced tax attorney who can help you stay out of trouble with the IRS.

 

Why the Self-Employed are a Prime IRS Target in Lousiana

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While the IRS maintains that audits are largely random, in truth there are “triggers” which raise a red flag to the IRS and one of those triggers lie in the classification of “self-employed.” The IRS claims that the majority of tax cheaters happen to be self-employed, therefore this group gets special attention and are almost always looked at harder than regular wage earners. The IRS employs some 47,000 workers, and the largest division in the IRS oversees tax returns from the self-employed and small business owners. Many small business owners feel they are largely “off the radar,” since their business doesn’t make that much yearly income. Don’t fall into this trap!

Whether your business makes $500,000 per year, $35,000 per year, if you have been foolish enough to cut any corners you run the risk of being audited—or worse, being under criminal investigation. During such an investigation, the IRS has no trouble getting their hands on your bank and other financial records and their auditors are trained to find unreported income. In fact, should you be audited, you will be asked to prove whether all your income or your businesses sales and receipts are properly documented. If you claimed any type of personal living expenses as business expenses, it is a pretty sure bet an auditor will catch such misclassifications. If your lifestyle obviously exceeds the amount of income you have reported then you will be asked to explain, and if you claimed substantial business entertainment expenses or wrote off travel expenses which was not truly business-related, expect repercussions.

For the self-employed, interestingly enough the majority of audits are directed at artists and musicians, however the IRS will look closely at the address of any self-employed person. Why you ask? An individual with a Manhattan address who is claiming to make $20,000 per year will automatically be flagged. The IRS is well aware of the cost of living across the nation, so don’t assume they won’t know that you are living in a high-end neighborhood while turning in very little income. Farmers are another group which gets “special” IRS treatment after one study undertaken by the IRS found that less than 25% of income earned by farmers gets reported. Plumbers, electrician and those in the construction industry will also be subject to special scrutiny by the IRS. The agency is well aware of what the average plumber or electrician makes, so if you are turning in $25,000 per year, you are risking an audit.

The past decade or so has seen the level of computer systems for the IRS increase significantly allowing the agency to more easily extract unpaid taxes from the self-employed and small business owners. More audits are routinely performed; in 2009 approximately 1.5 audits were directed toward those making less than $200,000, while only 29,000 audits were directed at those earning more than a million dollars a year. This should tell you that that even though you may feel like “small potatoes,” unworthy of IRS scrutiny, the IRS feels differently.

If you are a self-employed taxpayer or a small business owner, first get professional help sorting out your taxes and if you have any doubts about the legitimacy of deductions or other tax issues, consult a knowledgeable tax attorney sooner rather than later.