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.

What You Need to Know About Tax Changes for 2013

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As the “fiscal cliff” deadline looms, many taxpayers are becoming increasingly nervous about how the tax changes will affect them in the upcoming year. Those who have done a bit of year-end planning may find themselves ahead of the game when April 15th rolls around. While there may be more changes to come, here are some of the changes which have already been put into place for 2013:

  • Increased limitation on 401(k) maximum amount from $17,000 -$17,500. Those over 50 are still eligible for the $5,500 “catch up provision” which could make the total pre-tax deferral amount as much as $23,000.
  • The gift tax will increase to $14,000 per person in 2013 or $28,000 for a married couple.
  • Flexible spending accounts in the workplace which had a $5,000 yearly cap will move down to $2,500 meaning you should consult a tax professional to determine the amount you choose to set aside in your FSA plan.
  • In 2013 you will be allowed up to $1,000 of tax free earnings through something known as the “kiddie tax.” Parents should consider such plans as the 529 plan, Uniform Gifts to Minors Act and Uniform Transfer to Minors Act

Depending on the outcome of the fiscal cliff talks, payroll taxes could go up, income tax rates could go up, dividend and capital gains taxes could increase and the child tax credit could be slashed in half. Lawmakers have also kicked around the idea of limiting the current deduction homeowners are allowed to take for mortgage interest—a move which could seriously impacts homeowners, particularly those with larger mortgages.

How You Can Prepare for the Changes

As always, you must keep meticulous records if you plan on itemizing deductions, and you still have until December 31st to make donations and claim them in 2013. For donations under $250, keep an accurate banking record however for donations above $250 it is necessary that you obtain a correctly worded acknowledgement letter regarding the donation. If you have mountains of medical bills and are expecting more, try to get any necessary appointments in before the end of 2012. The law currently mandates that 7.5% of wage earners’ adjusted gross income must be spent on medical and dental costs prior to itemizing them however that figure will rise to 10% in 2013.

As of January 1, 2013, workers who earn more than $200,000 will experience more deductions from their paycheck, and the Medicare tax on wages increases from 1.45 to 2.35 percent. The Educator Expense deduction in the amount of $250, given to teachers who purchased classroom items which were non-reimbursable through their school was allowed to expire along with the deduction for tuition, books and other related college expenses. If you are uncertain about how any of the tax changes which have already taken place or may occur will affect your finances it is important that you speak to a tax professional as well as a tax attorney who can help you determine the best course of action, particularly if you already owe back taxes to the IRS.

When You Should Not Take Advantage of a Tax “Loophole”

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Most of us think of a tax loophole as a gift from the IRS. A tax loophole is actually an exploitation of a current tax law which allows the taxpayer to reduce or even eliminate taxes owed. A prime example of a tax loophole is the substantial tax break which was offered several years ago to small businesses that purchased SUVs for their business transportation needs. This particular tax law allowed 50% use of the vehicles to be for personal use. Many small business owners took this opportunity to upgrade their personal vehicle to receive this tax credit, thus exploiting the way the law is written for personal gain.

It is a sure bet that few legislators would define changes to the tax code as a loophole yet once the new law goes into effect, experts in tax laws may be able to discover flaws in the wording which allow taxpayers to get an unintended break. In some instances this type of loophole could be reported to lawmakers and the law re-written, however other loopholes could exist for years until finally discovered. Consider the tax known as the marriage penalty which caused married couples to pay more taxes than unmarried couples with the same income. Some couples decided to get a quickie divorce in a foreign country prior to the last day of the year, remarrying (legally) when January 1st rolled around. This is an obvious tax loophole which writers of the tax code simply never anticipated.

More Unexpected Tax Loopholes

Lest you be under the impression that tax loopholes are not a huge issue, consider the fact that between 2008 and 2010 a significant number of the Fortune 500 companies paid more for lobbyists than they paid in taxes in order to lodge themselves firmly in the pocket of Congress and, in effect buy the tax breaks and loopholes which would benefit their company. Not only did some 30 of these firms make billions in profits, they also avoided paying taxes and received over $10 billion in rebates. These, of course, are the blatantly obvious tax loopholes, yet there are hundreds more taken advantage of each and every year when tax season rolls around.

The Risks of Taking Advantage of Tax Loopholes

Be aware that engaging in tax loopholes can be a potentially risky business. Simply because the tax laws are laborious and, in many cases, ambiguous, is no excuse for skating out on the thin ice of a tax loophole, particularly one you are well aware was not meant to be used in the way you are anticipating. Should your tax returns be randomly selected for an audit, you may wish you had avoided that loophole altogether when you are forced to explain it to the IRS.

Even though you may attempt to justify using a tax loophole to your advantage, the reality is that should you get caught, you could end up paying back taxes as well as penalties and interest for doing something you knew you should have avoided. If you are uncertain whether a particular tax law could help you out—legitimately—talk to a tax professional If you find yourself in trouble with the IRS because you have indulged in tax loopholes in the past, find a knowledgeable tax attorney as soon as possible.

 

Married Filing Separate Taxpayer Has Mortgage Interest Deductions Reduced

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A married taxpayer filing “married filing separate” took the mortgage interest deduction on a house purchased with a family member.  The court recognized that that Congress did not intend for “married filing separate” taxpayers to be able to take the full amount of the interest deductions allowable under Section 163.  The taxpayers deductions for mortgage interest and home equity debt were limited to $500,000 and $50,000.

Bronstein v. Commissioner, 138 TC No. 21, May 17, 2012

Tax Attorney Reports Offer in Compromise Allows IRS to Retain Stimulus Rebates and Refundable Credits

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The taxpayers, attempting to settle taxes with the IRS, signed standard Offer in Compromise (“OIC”) forms, including IRS Form 656, the required form for OIC filers.  The OIC was accepted by the IRS in 2007.  For the 2007 year and on the taxpayer’s 2007 return, filed in 2008, the taxpayer’s claimed an earned income tax credit, a child tax credit.  Additionally, in 2008, the taxpayer’s were authorized an economic stimulus payment.  Under the OIC program, the IRS takes into account “additional consideration” as increases to the OIC amount.  Generally, the IRS will retain any refunds due to the taxpayer in the calendar year in which the IRS accepts the OIC.  As a result, the IRS was allowed to retain the refundable EITC and additional child tax credits as “additional consideration” as they were related to the 2007 tax year.  However, because the rebate was an advance on the 2008 tax year, the taxpayers were allowed to retain the stimulus payment.

See Sarmiento v. United States, Nos. Nos. 11–3752 (Lead), 11–4495(XAP), (2d Cir 2012)

Contributions to LLC Wholly Owned by Charity are Made to Charity

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The IRS  has clarified that contributions to a single member LLC, owned by a charity, are made to the Charity.  The IRS formally recognizes the disregarded status of single member LLCs in the charitable organization context, consistent with the treatment of these single member LLC disregarded entities.

IRS Notice 2012-52.

Louisiana Tax Lawyer Explains Fast TRACK Settlement for Tax Exempt Entities

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The IRS made permanent the fast track settlement program with regard to tax exempt and governmental entities.  Eligible cases under this fast track program will receive the expedited settlement process.  However, a number of exclusions exist with the program.

See IRS Announcement 2012-34

Children Must be US Citizens for Dependency Exemption

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The court, interpreting Section 152, and Reg. Section 1.152-2, held that the couple residing in Israel with non-citizen children were not entitled to the dependency exemptions.

Carlbach and Fried v. Commissioner, 139 TC 1, July 19, 2012.

Masonry Workers held to be Employees, not Independent Contractors

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Applying the common law employee test, the tax court held that masonry workers were employees, and not independent contractors for purposes of federal income tax, FICA and FUTA withholding.  The tax court noted the degree of control was sufficient to indicate an employer / employee relationship.  The workers were paid an hourly wage, were employed at-will, and did not have profit or loss possibilities based on timely performance or quality of work.  Because of increasing scrutiny of the employer / employee relationship, to obtain relief from misclassification of independent contractors, taxpayers are advised to be current on all tax filing obligations, with care paid to the 1099 reporting responsibilities.

See Atlantic Coast Masonry, Inc. v. Commissioner T.C. Memo 2012-233