In business as in life, there are only two certainties: death and taxes. You cannot avoid the former, but there is a lot you can do to avoid expensive mistakes on the latter!
If you run a small business, one of the most important things you need to do from a tax standpoint is to classify the people who work for you. If you err in this important task, you may face many issues with the IRS!
Here are 11 facts you need to know about whether to classify someone who works for you as a sales contractor versus an employee.
1. Misclassification is a Common Mistake
One of the biggest mistakes employers make in running their businesses is the misclassification of employees.
When you hire someone, you need to immediately establish whether they are a contractor or an employee. A contractor files with the Internal Revenue Service under 1099. An employee files a W2.
When you’ start to hire employees, you have put your business in a new position with additional tax obligations. You need to be certain you know how to file for W-2 employees, which is different than when you hire 1099 contractors.
For employees, you have to withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on their wages. You do not generally have to do that with independent or sales contractors.
Too many owners of small and large businesses fail to classify properly, exposing their organizations to dire consequences. It’s tempting to classify everyone as contractors to save money when your budget is tight.
Why pay people for time spent learning the ropes or sick days if you don’t have to?
Because if you don’t, you can get into a lot of trouble.
2. The Penalties for Misclassification Can Crush Your Business
Failing to make mandatory payroll deductions can result in high penalties. They may require you to cough up a lot of money that you don’t have on hand for back taxes and fees.
You may face lawsuits from affected employees. You will surely need a lawyer to help you sort out your issues with both the IRS and your staff, and that is not cheap either.
There are all sorts of ancillary costs as well if you are found in non-compliance with these rules. The reputation of your company may be negatively affected. Many customers do not want to patronize a business when they think it does not treat its employees well.
3. An Employee Gets Taxes Withheld
So, how can you avoid these costly mistakes? Once you start paying people in the course of business, you need to learn what separates an employee from a sales contractor.
Once you determine the needs of your business, you can better decide what kind of support you need. That will determine how you classify the people you hire.
If you need a right-hand man who is with you every day and on whom you rely for a variety of tasks, it sounds like you need an employee. If you need a team of people who go out and conduct sales on commission, they are more likely to be 1099s.
The important difference is that for employees, the company withholds income tax, Social Security, and Medicare from their wages. You don’t have to do this for contractors. Hiring contractors can save a company up to approximately 30% in start-up costs.
Federal employment and labor laws under statutes like OSHA and EEOC do not apply if you only use independent contractors. This is appealing because of the expensive regulatory requirements under these laws. However, if you have miscategorized the people who work for you, you may find out too late that you should have been following them!
4. Salary vs Commission
There are several criteria by which the IRS and other authorities evaluate whether someone is an employee or a contractor. One of the most important factors to look at is the manner of payment.
If you pay someone every two weeks or every week, that typically falls into the category of a salary which a company would pay one of their employees. If you pay them the same amount every pay period, that also looks like a salary.
Contractors are generally paid by the project. You might pay them half upfront, and the other half when they complete the project. If the person is doing sales for you and you pay them if and when they make a sale, that looks more like a contractor relationship.
For salespeople, arrangements including commissions and “draws” on future commissions can create complications in classification. Some courts have followed a “20-factor test” to determine employee versus a contractor with salespeople.
A court in Iowa ruled that salesmen were employees, not independent contractors, in a case where the salesmen were paid by commission, but they could take a draw against next week’s commission. It found that the commission indicated independent contractor status, but the draw indicated salary and employee status.
Paying for expenses and providing a company car to the salesmen also indicated that they were employees.
5. Control or Autonomy
Another criterion for classifying someone as an employee or a sales contractor is how much control they have over their work. Do they make their own hours? Can they decide when, where and how they will get the job done?
If you instruct someone to go out and sell ten vacuum cleaners but you do not prescribe how and where and when she should do it, she is probably your contractor. On the other hand, if you tell someone they must sit in your office and make phone calls every day from 9 am to 5 pm, that looks like they’re an employee.
Contractors generally work on a project by project basis. They can say no to you if you give them an assignment. An employee would be less likely to say no to an assignment because you have control over them.
Sales contractors can work for many different companies. They may file as self-employed and even have their own LLC or other entity which you pay.
If they have to travel or drive for work, they probably have their own cars, pay for their own gas, and cover their own expenses. They should be including these costs into the price they charge you for the project.
A boss has more oversight authority over employees than contractors, who can even pay someone else to get the job done if they like. With higher responsibility for the people who work for you, you have higher levels of obligations: to pay payroll taxes, offer overtime, and give paid time off.
6. What’s the Relationship?
Another thing that a court or the IRS may scrutinize if they need to determine whether someone is an employee or a contractor is the relationship between the person working and the person paying them. Do they have a contract dictating their terms?
Is the worker a permanent member of the company? Are they integral to the company’s functioning? Does the boss rely on them for strategy, planning, and other long term initiatives? Can he hire and fire others?
These would all indicate that the worker is an employee.
Do customers associate the person with the company? Do they wear a uniform or a name tag with the company brand? Are they on the company website?
Although not conclusive, these factors contribute to conveying the nature of the relationship as permanent and integral instead of temporary and transient.
Benefits are another indication of employment status. That can be more than could be considered a benefit.
Can you fire the person any time you feel like it, or do you have to buy them out of a contract? If you can terminate them at any time, they are definitely your employee and you must withhold all relevant taxes and FICA.
Conversely, contractors can’t quit in the middle of a project without incurring liability for nonperformance.
7. Training Is Also a Factor
Contractors are usually considered experts: you hire them to get the job done because they hit the ground running. Employees are given training and are expected to commit themselves to the company for an extended period of time. Depending on your business model, you may want to encourage retention by offering professional development and other incentives for people to stay with you for a long time.
On the other hand, if your goal is to move product, you may just want a contractor who knows how to sell and who you don’t have to spend a lot of time training.
8. Is W2 Better than W9?
Your goals, budget and business objectives will determine what is better for your company: employees or contractors. Employees require a bigger initial outlay of funds because you pay their taxes and benefits. If you are looking for a long term investment in a loyal workforce, you may want to go with investing in your people upfront.
On the other hand, you may have liquidity issues and be unable to commit to paying for benefits for all the people you need to help get the business off the ground.
Neither option is necessarily the best, because it depends on what you do or sell and where you plan to go with your venture. However, whichever one you decide, you need to file appropriately or else.
9. What Happens if You Make an Employee Classification Mistake?
If money is tight, you may want to avoid paying Medicare or social security taxes, overtime or benefits. However, misclassifying can lead to very expensive fines, costing you much more money.
If an audit reveals that you have classified someone as 1099 when they should have been a W2, you will have to pay a fine for each misclassification. You will also be responsible for all the taxes you should have paid, plus interest. The fines go up the longer the taxes are due.
You may also be subject to individual or class-action suits by employees. The costs to you in facing penalties for violations may exceed anything you might have initially paid had you set up everything properly. That’s why it is critical to confer with a tax attorney before you set up your own business and start hiring people.
If the IRS suspects you of having misclassified people intentionally, you risk criminal and civil penalties and sanctions.
10. Reporting by Employees/Contractors
Besides being audited, the other way that employers get into trouble in this area is when they are reported by someone who works for them. Individuals can contact the IRS anonymously if they think they should be being paid as an employee instead of a contractor, or vice versa.
If you sense that someone who works for you is disgruntled with their classification, it is in both of your best interests to resolve the situation amicably. You would not want someone to retaliate by flagging you to the IRS.
Whistleblowers are taken seriously. The government has prioritized targeting companies who misclassify employees, focusing on low wage workers in the restaurant, hotel, construction, janitorial, agriculture, retail, and manufacturing industries, and it has recovered billions of dollars in its efforts.
11. Legal Liability
If you are found to have mistakenly classified someone who works for you, they may go after you in court. The most common lawsuit compensation for misclassified workers is back wages in the form of unpaid overtime and minimum wage. Under the Fair Labor Standard Act, plaintiffs can seek liquidated damages and recover up to double what is owed to them.
The most common compensation for misclassified workers is back wages—unpaid overtime and minimum wage.
Misclassified workers may also be eligible for expense reimbursement. And once a court has determined that a worker is an employee, she is then eligible for unemployment insurance, workers compensation benefits, and other benefits.
If there are numerous people in the same boat, they could even get together in a class-action suit, which can be very damaging to your bottom end and reputation.
Sales Contractor or Employee? When in Doubt, Get Help
The definition of sales contractor and employee are hardly crystal clear, and the consequences of classifying someone incorrectly can be huge. Do yourself and your business a favor by getting professional advice. By speaking to an experienced tax attorney here at Silver Tax Group, you can set up a structure for your business which will help all your dreams come true, and keep you from getting in trouble with the IRS.
For more information on effective tax strategies for small and large business enterprises, check out our blog.