Association of Independent Professionals and the Self-Employed

Transcription

[Music] Employee vs. Independent Contractor -- A classification you do not want to get wrong. This video covers the primary factors that determine if a worker is classified as an employee or an independent contractor and what you can do to help protect yourself from costly taxes and penalties for getting this wrong. [Music] My name is John Olin. I am a native of Yuma, Arizona and lived in Tempe just long enough to graduate from Arizona State University in 1989 with a bachelors degree in Accountancy before moving back to Yuma to practice accounting in local CPA firms including my own firm, Olin Business Solutions, which I started in 2006 to provide accounting services to Arizona businesses. After passing the CPA exam and obtaining the necessary work experience, I was certified in 1994 by the Arizona State Board of Accountancy. Since becoming certified, I have been involved with many professional organizationsl; such as the American Institute of Certified Public Accountants, the Arizona, and by default, the National Independent Auto Dealers Association, the Yuma County Chamber of Commerce, the Southwest Contractors Association, and the Arizona Society of Certified public accountants. I have a very extensive computer background. I picked up my first computer, an apple 2E, in 1983 and have been writing software ever since. In 1997 I started using Visual Basic for Applications and Microsoft Access to streamline my software development using a database application approach. I have authored/developed many accounting applications including a free payroll module that runs Arizona payrolls. It prints checks, journals and various other reports. Before I start, I need to get a quick disclosure out the way. This disclosure is also reproduced at the very end of this video with a full explanation as to its existence. Essentially, should you ever incur penalties related to the material covered in this presentation; you can not use this video or any of the accompanying materials as an excuse to get out of the penalties. With all that out of the way, now we're ready to get started . . . [Pause] Because the whole discussion of this video centers around 'services' provided to companies, I am going to start off by doing my best to explain when a transaction is considered a 'service'. When a vendor uses their personal skills and labor (like cleaning, installing something, repair work, legal work, accounting, etcetera) and they use their personal skills and labor to do something for your company, this is known as a service. It gets tricky when the transaction involves a combination of service and goods. If the goods are incidental to the service (for example: a plumber might use a couple pieces of pipe and some glue to fix your plumbing), then the overall transaction is still considered a service. You'll notice that in the case of the plumbing repair the materials used only represent 10% of the total contract. Where as if you bought some appliances and the plumber delivers and installs them, well the service is incidental to the products and the overall transaction is considered to be goods and not a service. In this case the appliances represent 90% of the total transaction. I find it interesting that the IRS uses a drywall company in their 2011 1099-MISC instructions as an example of a service provider. One of the industries that IRS has square in its crosshairs is the construction industry. I would say that the materials of a drywall job account for about 40% of the total transaction. Even if materials or goods represent a large portion of the transaction, the transaction could still be considered a service. The IRS issued Rev Ruling 81-232 where an insurance company made a payment to an unincorporated repair shop for repair of an insured automobile. The repair contract required payment of $300 for labor and $700 for new parts that were installed, including a fender, a grill, a radiator, and a bumper. The IRS ruled that although the contract required the furnishing of certain parts, the repair shop was in the repair business (not the parts business) and the obligation to furnish certain parts was incidental to the obligation to repair the car. Therefore payment under the contract was not in any part a payment of a bill for merchandise and that the insurance company had a reporting requirement to report the entire $1,000 as non-employee compensation. In this case the IRS found that the repair shop was a service provider even though the materials represented 70% of the transaction. Sometimes it is hard to tell if the overall transaction is a service or not. It's tricky. Since it's only tricky when the vendor is also supplying goods, the vendor is most likely an independent contractor -- they have their own business and they're definitely not an employee. You're just trying to determine if you have a reporting requirement to issue them a 1099 because they are a service provider. Issuing 1099s to vendors (whether they are a service provider or not) does not cost the company hardly anything and you can't get into trouble for issuing too many 1099s. It's better to error towards service. So if you're not sure, just go with service provider and issue them a 1099. It's only tricky when the vendor is also providing a significant amount of materials or goods. If they are providing mostly service, then there is really no question, they are a service provider. [Pause] Once you have determined that someone is a service provider, the IRS – and just about every other taxing authority -- requires that you classify them into one of two classifications: Employee or Independent Contractor. Most of this video explores the factors in determining the classification and the cost of getting it wrong. There are many factors that determine the difference between Employee & Independent Contractor, but the primary factor is CONTROL. Who is in control? When it's the person paying for the services (for the rest of this video, we'll call this person the company), this would indicate an employer-employee type relationship. When it's the person providing the service (for the rest of this video, we'll call this person the worker), then you have an independent contractor. Employee: Generally a worker providing services will be considered an employee as the company exerts significant control over things like: when and how long the worker works by scheduling hours; how much the worker will make by setting things like rate of pay; what methods are used by providing training, materials, and equipment; where the work is done by having facilities and/or assigning the worker to job sites; who performs the work by being the one in charge of assigning, hiring, and firing workers; and financial control by paying for a majority of the expenses and bearing the risk of loss. The company is going to want to exert control when the work being done is in direct connection with the end product that's going to be presented to the company's customers and the company's reputation is on the line. When the company exerts a significant amount of control this would indicate an employer-employee type relationship. Independent Contractor: Workers will generally be determined to be an Independent contractor when they exert control over: when and how long they work by scheduling jobs to fit within their schedule as long as they can finish on time; what the work is worth by providing prices on jobs through documents like bids and contracts; what methods are used by using their own methods (that they have probably developed over many years of experience) and their own materials & equipment; where the work is done by determining the best location to do the work (some work may be able to be done in their shop); who performs the work by being able to delegate work to who ever they want; and financial control by paying for a majority of the expenses and bearing the risk of loss. In this case the worker, who is providing the service, is in control (not the payer) indicating an independent contractor type relationship. The IRS does not have any one set of definitive rules where you do this, this, and that AND you are guaranteed of getting the classification correct. Instead the classification is determined on a case by case basis by taking into consideration the facts & circumstances of each case. There has been a lot of written information documenting the IRS's interpretation of various facts and circumstances. To get a good understanding of exactly what it is the IRS looks at when making the determination; we will look over Form SS-8. Form SS-8 is used to request the IRS to make a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. The form is normally used when someone wants to contest their classification. If as a result of the request, the IRS makes a determination, that determination is automatically binding on all parties involved. Form SS-8 has a series of questions. These questions represent factors that the IRS feels are important in determining the proper classification. When looking at the factors, you can think of it like scoring a boxing match –- you're scoring points and the scoring has a certain amount of subjectivity to it and the IRS is biased towards the employee classification. There are about 50 to 60 questions. It's really important to remember that even though several of the factors may point to one classification, the proper classification is determined by taking into account all the facts & circumstances and weighing them against each other. Let's examine the key factors, as if we were a General Contractor, using a couple of different transactions. In our examples we will use: one transaction where a worker is providing framing services and another transaction where a worker is providing tax preparation services. Part I: Question 3. Total number of workers who performed or are performing the same or similar services. If you are a construction company, you are likely to have several people performing construction type services and are going to want to exercise a certain amount of control over their work as their performance is a direct reflection of your company to your clients. Because companies are inclined to exercise control over these workers and control is the primary factor, score one for the employee classification for the Framer. While if the person is providing a service that no one else in your construction company does (say preparing an income tax return) then you are less likely to want to exercise control because the construction company is not in the business of preparing tax returns and an incorrect tax return is not a direct reflection of your company to its customers. Because the company is not inclined to protect its reputation and exert a significant amount of control over this type of worker, score one for independent contractor classification. Part I: Question 4. How did the worker obtain the job? Having the Framer fill out forms like job applications and/or go through something like an interview process would indicate an employee classification. While documents like bids and contracts are normally used when dealing with people who have their own business (independent contractor). Your CPA may have you sign an engagement letter for your tax preparation work. Part I: Question 6. Describe the firms business. Similar to Question 3 because the company is in the construction business and Framing is a type of construction service, you would need to score one for the employee classification. Where as the worker providing tax preparation services does not have much in common with construction services, score one for the independent contractor classification. Part I: Question 10. Did the worker perform services for the firm in any capacity before providing the services that are the subject of this determination request? Independent Contractors are contracted on a job by job basis – one contract at a time. Where as an employee will have a continuing relationship where they are constantly assigned to new tasks as they complete older tasks. If a construction company hires the Framer on a constant basis through out several years, score one for the employee classification. However, if the person is the company's CPA who is contracted just a couple times a year, score one for independent contractor. Also … if the worker has a long history of being classified as an employee in the past and then the company switches them to independent contractor, you need to score a big one for the employee classification. On the other hand if there is a long history of being classified as independent contractor and the worker is switched to employee, you can score a little one for the independent contractor classification. Remember, the IRS is biased towards employee. Part I: Question 11. If the work is done under a written agreement between the firm and the worker, attach a copy. Describe the terms and conditions of the work arrangement. If there is an agreement and it reads like an employee manual, obviously you score one for the employee classification. If the agreement reads more like a contract (say like an Engagement letter from your CPA to prepare your tax return) then score one for the independent contractor classification. Ok. You're starting to get the idea of how this is going, so I'm going to try and speed it up just a little as we move into Part II Behavioral Control. Part II: Question 1. What specific training and/or instruction is the worker given by the firm? If the General Contractor exerts control over the Framer by providing any training and/or instructions, you would need to score one for the employee classification. I'm sure that a construction company would not train or instruct their CPA on how to complete tax returns. Score one for independent contractor for the worker providing your tax preparation. Part II: Question 2. How does the worker receive work assignments? If the company has something like a work schedule for the worker, you're going to need to score one for the employee classification. Part II: Question 3. Who determines the methods by which the assignments are performed? In some ways this is similar to Question 1 just a couple questions up. If the company is exerting control over the worker by telling them what methods to use, this would indicate an employer-employee relationship and you would need to score one for the employee classification. A construction company is probably not going to be dictating the methods that their CPA uses to perform their tax preparation. Obviously, the construction company would score one for the independent contractor classification for the worker providing tax preparation services. Part II: Question 4. Who is the worker required to contact if problems or complaints arise and who is responsible for their resolution? Employees will normally take their problems to someone within the company. Independent contractors normally take care of their own problems. Part II: Question 5. What types of reports are required from the worker? Score one for the employee classification if the worker has to report something like their time or is accountable for their time in some other way; like a daily production report. The only thing you'll probably end up getting from the tax preparer is your completed return. Part II: Question 6. Describe the worker's daily routine such as his or her schedule or hours. It's fairly common for employers to set daily routines or schedules for employees. Companies do not normally set a daily routine or schedule for workers performing services as an independent contractor. There might be a general time line for the completion of a job, but the exact hours are left up to the worker. Part II: Question 7. At what location(s) does the worker perform services? Independent contractors typically have their own facilities and do at least some of the work at their own place. Part II: Question 8. Describe any meetings the worker is required to attend and any penalties for not attending. Independent contractors may attend a few planning meetings here and there, but it is fairly common for companies to require their employees to report to company meetings on a regular basis. Part II: Question 9. Is the worker required to provide the services personally? Independent contractors typically have the ability to assign work to who ever they want; the company is just concerned about paying the agreed upon price and that the job is done satisfactorily. Not too many employees can call in and explain that they will not be able to make it in and are sending a stranger in their place. Part II: Question 10. If substitutes or helpers are needed, who hires them? Independent contractors hire who ever they want; as long as they can get the job done. Employees do not typically have hiring authority. Part II: Question 11. If the worker hires the substitutes or helpers, is approval required? Again, independent contractors hire who they want; no approval needed. If the worker can hire someone, but they need approval, this would indicate that they are an employee. Part II: Question 12. Who pays the substitutes or helpers? Independent contractors pay their own workers. If the company is paying the other workers, score one for the employee classification. Part II: Question 13. Is the worker reimbursed if the worker pays the substitutes or helpers? Similar to Question 12: If the company is reimbursing the worker for the helpers, this indicates an employer-employee relationship. Ok. Now I'm going to step it up just a little bit more. Part three has to do with financial control. Part III: Question 1. List the supplies, equipment, materials, and property provided by each party. Independent contractors have their own supplies, equipment materials, and property. Employees may have some, but usually not a significant amount. The fact that the Framer has some tools (like a Skillsaw, hammer, pouch full of other small tools like punches and stuff) will not count for much when compared to all the tools in the General Contractors truck (compressors, expensive hand tools, etc). Part III: Question 2. Does the worker lease equipment, space, or a facility. This is really close to question one, except there's a lease agreement instead of outright ownership. Part III: Question 3. What expenses are incurred by the worker in the performance of services for the firm? Independent contractors will typically pay for nearly all the expenses of getting a job done, while employees usually have the employer pay for the expenses. So if the worker has to pay for a significant amount of expenses, you would score one for the independent contractor classification. If the worker is not paying for a significant amount of expenses. Yep, score one for employee. Part III: Question 4. Specify which, if any, expenses are reimbursed. Employees do not normally pay for a significant amount of expenses; and if they do, they get reimbursed. Independent contractors usually pay for their own expenses and there would be no need for reimbursement. If there are lots of reimbursements, you would score another one for the employee classification. Part III: Question 5. Type of pay the worker receives. Paying a salary or a commission or an hourly wage or by piece work would indicate an employer-employee type relationship. Independent contractors are normally paid out in lump sums as determined by an agreed upon contract. Part III: Question 6. Is the worker allowed a drawing account for advances? If the worker is getting money on a constant basis from the company, this would indicate an employer-employee relationship. Part III: Question 7. Whom does the customer pay? This one is a tricky question because it introduces a third party. If there is a third party customer and that customer is paying the company for the services that worker is performing, you can score one for employee classification. Part III: Question 8. Does the firm carry workers' compensation insurance on the worker? Independent contractors normally have their own insurance. Part III: Question 9. What economic loss or financial risk, if any, can the worker incur beyond the normal loss of salary? Because independent contractors normally have their own supplies and equipment, they are at risk of loss should there be some kind of theft or damage. If a company contracts a CPA to provide tax preparation services, the CPA will never call the company to replace their broken down computers. Part III: Question 10. Does the worker establish the level of payment for the services provided or the products sold? Employers usually dictate what a worker is paid by setting some type of rate. While independent contractors usually set the rates they charge. If the company is setting the rates, score one for employee. The last part I'm going to cover in this video is Part four which just straight out gets down to it, 'What is your relationship?' Part IV: Question 1. Please check the benefits available to the worker. For every one of those boxes you check (paid vacations, sick pay, paid holidays, personal days, pensions, insurance benefits, or bonuses), you can score one for employee. Part IV: Question 2. Can the relationship be terminated by either party without incurring liability or penalty? Employees can normally just quit and walk away. While independent contractors are usually under contract to perform and can be compelled to perform or pay damages. Part IV: Question 3. Did the worker perform similar services for others during the time period entered in Part 1, line1? Independent contractors almost always perform services for many many different customers, while an employee usually just works for one to a small handful of companies. Part IV: Question 4. Describe any agreements prohibiting competition between the worker and the firm while the worker is performing services or during any later period. Because independent contractors want to do work for many many different customers, they would never dream of entering into an agreement where they can not perform services for others. But it's not uncommon for companies to require their employees to enter into some type of non-compete agreement. Part IV: Question 5. Is the worker a member of a union? A union would indicate an employer-employee type relationship. Also, you may want to look at who is paying the dues. Part IV: Question 6. What type of advertising, if any, does the worker do? Independent contractors normally advertise because they want lots of customers, while employees do not have any need for advertising. Part IV: Question 7. If the worker assembles or processes a product at home, who provides the materials and instructions or pattern? If the company provides materials or instructions, they are exerting control and this would indicate an employer-employee type relationship. Part IV: Question 9. How does the firm represent the worker to its customers, and under whose business name does the worker perform these services? Independent contractors work under their own name. If the company is running around referring to the worker as their employee to their customers, you can score one for the employee classification. Part IV: Question 10. If the worker no longer performs services for the firm, how did the relationship end? Employees quit or get fired. Independent contractors complete jobs or get compelled to complete them or go out of business. That completes the SS-8 questions; that's a lot to take in. As a review, you could always print the SS-8 out and score it as you run your finger down through the questions. Here's the simplified answer: Step back a little bit and take an honest look at the person. Are they truly engaged in their own independent trade, occupation, profession, or business? Are they contracted on a job by job basis? Do they do work for other people? Do they have a license? Do they advertise? Do they have their own insurance? Do they have the risk of loosing money? Do they determine when and how the work is done? Do they have their own facilities and/or equipment? The big questions: Who's in control of the services being performed? The company or the worker? Does this person really have their own business? Once you determine the proper classification for your workers, you are going to want to file all the proper paperwork. Because this video is about getting the classification correct and not really about fulfilling reporting requirements, I'm going to touch very briefly on the forms used: Reporting for independent contractors is relatively easy. Before they provide services, you'll want them to fill out a W-9 which is a very simple one page form requesting the service providers basic information. At the end of the year you'll fill out a 1099-MISC for each worker. Give the workers their copy and submit a copy to the taxing authorities along with a transmittal form (1096 for federal) and you're done. Reporting for employees is somewhat more complicated which is one of the reasons that companies are tempted to miss-classify their workers as independent contractors. Before they provide services, you'll want them to fill out several forms: W-4 for federal withholding, a state withholding form (A-4 in Arizona), I-9 to show that they are eligible to work in the US, and possible a few other forms. Each time you pay the worker, you'll normally report the taxes withheld on some type of paycheck stub. You are then required to periodically submit the withholdings plus company taxes to the proper taxing authorities. At the end of each quarter, you'll prepare a series of reports: normally a 941 for federal taxes, in Arizona an A1-QRT for state taxes and a DES report for State Unemployment. Then at the end of the year in addition to your quarterly reports, you'll need to prepare all the annual reports. Such as: the 940 for Federal Unemployment; W2s for the employee, W2s for the federal government along with the W3 transmittal , and W2s for the state along with a transmittal form which is the A1-R in Arizona. Whether you have one employee or a hundred, the reporting requirements are pretty much the same and start when you hire your first employee. Even though the reporting for employees is considerably more involved than the reporting for independent contractors, computer programs help to significantly reduce the calculating and reporting burden to a level that makes compliance relatively easy. Because of the extra paper work and the extra taxes (about 10%), companies are tempted to classify employees as independent contractors. Let's look at the cost getting it wrong: Say you pay an Individual $20,000 for the year. If you had paid them as an employee you might have paid them $16,000 ($20,000 less $4,000 of withholdings) and then paid out a corresponding $6,000 in tax payments. So your total cost would be $22,000. If you paid them as an independent contractor you would just pay them the $20,000 and be done with it and the worker is responsible for paying all their own taxes. While paying the worker as an employee can be a good deal for the worker because it takes care of their taxes, it cost the company an extra $2,000. This is one of the reasons why employers are tempted to miss-classify individuals as independent contractors. Now, if you issue the worker a 1099 for $20,000 for the year and their tax preparer helps them to determine that they were actually an employee; you could owe quite a bit more. Your worker may owe several thousand dollars on their tax return if reported as an independent contractor, but could actually have a refund of just over one thousand dollars if reported as an employee. If this person is an ex-worker and no longer providing services for you, which do you think they will choose? Let's take a look at the numbers. When they choose to be treated as an employee so they can get a large refund instead of owing several thousand, their accountant will now say that the $20,000 was the net paycheck and will 'gross it up' showing something like $25,000 as the gross pay with $5,000 of withholdings to get to the $20,000 you paid your worker (that's like an instant bonus for the worker). There are federal tax court cases supporting this position – such as Winter vs. US, cited as 86 AFTR 2d 2000-6846 (I've included a copy of this case in the materials on my website at www.OBSPLLC.com). They can do this by filling out two short forms: one to report the miss-classification, and a second form to report the 'correct' employee W-2 figures to the IRS. Now you are going to be out the $20,000 paid to the employee, about $8,000 in payroll taxes, and about $4,000 in penalties. So now instead of paying out $22,000 (if you had treated them as an employee from the beginning), you are going to be paying out $32,000. And if that's not enough, there could be even more taxes and penalties from the state. The state of California just passed bill 456 effective January 1st, 2012. Violation of the state statute carries exposure for a 'civil penalty' of between $5,000 and $15,000 for each violation; if the employer is found to have engaged 'in a pattern or practice of [those] violations,' the civil penalty is increased to $10,000 to $25,000 per violation. Add on another $5,000 (or maybe even $25,000, but we'll be nice and go for the smallest penalty) and now you're at $37,000 -- almost twice the original cost. All that seems pretty bad, but it can actually get worse. What makes this worse is the possibility that a taxing authority will examine all the other 'independent contractors' and discover more miss-classified workers that need to be reclassified and adjust everyone of them going back several years. The IRS is not just limited to getting the taxes from the company. Because they are payroll taxes, the IRS can potentially go after the personal assets of officers and anyone else that they deem to be a responsible party by assessing what's called the Trust Fund Recovery Penalty. Another thing to keep in mind is if the worker gets injured while performing services for you, the tax problem could easily be the least of your worries if they are not covered under a workmen's compensation insurance policy. The chance of a miss-classification being discovered is pretty high when compared to other compliance issues. Because workers could potentially owe a lot of taxes when filing their personal income tax returns as an independent contractor, but get back large refunds if filed as an employee, Ex-workers will be encouraged by their tax prepares to file as an employee and report the miss-classification to the IRS. I have heard that some preparers have stacks of the necessary forms already on their desk. Also, I have seen national ads for companies that want to 'help' those who have been miss-classified as independent contractors. If an employee gets injured, at some point a social worker might be asking them a series of questions to help determine how their medical bills are going to be paid. There are plenty of other methods of discovery -- like workers trying to claim unemployment, child support, court actions, various governmental audits including audits of your 'independent contractors' personal tax return. If you give someone a 1099 and they report it on their personal tax return with a bunch of deductions to help minimize their tax burden, your miss-classification may be discovered when your worker gets audited. Probably, the best chances are by ex-workers who would rather receive a large refund than owe a lot, and people who just want to create problems for you (other types of Xs). Here's the executive summary: Basically it's a two step process: First you must determine if the transactions constitute a purchase of merchandise or the purchase of services. If the worker is providing a service, then are they classified properly as an employee or independent contractor? I would highly recommend getting the worker classification correct which is why I choose to produce this video. I would lean towards employee. The bottom line is that you are taking large risks when you have employees miss-classified as independent contractors. It only cost the company about 10% extra to get it right and the company could be helping the worker out by taking care of the workers' taxes for them. The cost of getting it wrong is pretty steep and the chance of an improper classification being discovered is pretty good. Protect yourself by getting it right. As promised, here is an explanation as to the circular 230 disclosure that you frequently see in communications from individuals like CPAs. Some CPAs send it out on everything – including things like lunch invitations – because they want to make sure they never get into trouble on this one. Here it is: The IRS frequently assesses penalties against taxpayers. In certain cases taxpayers could get out of the penalties by saying that they relied on paid professional advice. There were some very aggressive firms that would promote some very abusive tax shelters that would never pass IRS scrutiny. These firms would explain to the clients that they need not worry about the penalties as they could get out of any penalties because the firm would provide them with the necessary written advice – even though the written advice was not supported at all by tax law & could be just flat out wrong. The firms did not care if the advice was incorrect, they would provide this advice with the sole purpose of being a means to avoid penalties. Obviously the IRS was not 'down' with this, so in about 2005 the IRS updated some rules in Circular 230 which regulates the conduct of tax professionals. Under the threat of severe penalties on the firms, the new rules essentially require tax professionals to either painstakingly document voluminous amounts of support for their position or provide the disclaimer you are reading here. The work needed to meet the requirements of circular 230 along with the extra liability of issuing a 'reliance opinion' make it very infeasible to produce products like this one, which is why many professionals just use the disclaimer. And now you know 'the rest of the story' for the Circular 230 disclosure. Hope you found the information in this video useful, & until next time: Hakuna Matata. [Music] [Music]