Employee vs. Independent Contractor - A practical discussion
BeyondPay is often asked by our clients if they can treat new payees as independent contractors instead of employees. Generally, the thought is that they could save some hassle or money by not hiring the person by “letting them take care of their own taxes.”
Our payroll systems, both our legacy product and our 2.0 system, can process payments to independent contractors and issue 1099’s instead of W-2’s at the end of the year. As a processor, BeyondPay defers to you and your accountant’s (or attorney’s) judgement as to how to classify the payee.
As a CPA, I have had this discussion with many clients over the years. The concept of whether a payee is an employee or independent contractor dates back to English common law. Although the IRS does provide some guidance, the facts and circumstances of each case are paramount in their decisions. However, I would say that when in doubt, the IRS tends to lean toward treating the person as an employee.
Under common-law rules, anyone who performs services for you is an employee if you can control what will be done and how it will be done. That casts a fairly large net. Some areas they may look at are regularity, where the services are performed, when they are performed, their ability to subcontract the work if they desire, permanency of the relationship, whether they can make a profit, whether they perform the same services for others, etc. In each circumstance, any one of these areas may carry more weight than another. You can see why this has become an area of question for employers, and an area of focus for IRS auditors. By the way, I believe that the Department of Labor generally has even tougher standards than the IRS.
Misclassification can carry heavy fines if there is no reasonable basis, and “slap-on-the-wrist” fines if there is reasonable basis and 1099’s are filed. All bets are off if you do not even file 1099’s and at least attempt to treat properly treat them as independent contractors. Let me share some stories as to why I would generally recommend outright hiring of people who provide you with services.
Many years ago, at a DOL audit, I had built a case for treating a group of payees as independent contractors. Roughly, they leaned toward independent contractor in nearly 17 of 20 common-law classification areas. I thought the audit was a slam-dunk. However, the auditor focused on one of the three exceptions, sat back in his chair, folded his arms, and said “convince me.” He would not be swayed, but we eventually did win after appealing to a supervisor.
In another situation, a company hired a family friend to clean their offices over the course of a year. “Mary” did have a cleaning business, and only cleaned for that one company. She had agreed to get a 1099 at the end of the year, and the owner of the company even agreed to pay a little more to “cover the self-employment tax.” Mary’s uncle was an accountant and prepared her taxes for her. He told her that “your boss should have withheld taxes” and he filed a complaint with the DOL. They showed up at the company’s door several weeks later and audited their entire company. The company can be held liable for back payroll taxes, and for not withholding income taxes. By the way, when the company was audited for workman’s compensation, there was no insurance certificate provided by Mary so the insurance company ended up charging workman’s compensation on the higher gross earnings. Some more perceived savings out the window!
The bottom line is that you should be very careful when trying to classify a payee as an independent contractor. Make sure you issue 1099’s (we can help you with that) and go overboard to create a file that shows that this payee is a legitimate business. Business cards, yellow page ads, insurance certificates, websites, and properly completed Form W9’s are all helpful upon an audit. Also, I would consider having your attorney draft an independent contractor agreement if you have further doubts.
I trust this article helps as you consider your options. Please feel free to comment, question, or tell your story in this forum.