By Richard A. Mann, Richard A. Mann PC
Many businesses are trying to avoid having employees due to the many regulations, penalties, governmental mandates and what they perceive as costly taxes and insurance. Is this a trap you are setting for yourself? Say you run a small law firm and you have a part time secretary, paralegal or assistant. (If not a law firm insert your business i.e. roofer, electrician, butcher, baker, or candle-stick maker.) What if that person also works elsewhere? Is that person an employee or independent contractor? You should first look to the IRS for guidance. When doing so you will find it is not a simple search. The IRS has 4 categories: 1) independent contractor, 2) employee (they call a common law employee), 3) statutory employee, and 4) a statutory nonemployee.
- Independent contractor: People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.
- Employee (common law employee): Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. The following 3 factors are also considered Behavioral Control, Financial Control and Relationship of the Parties. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed. Say you have a secretary, roofer, part-time baker etc. who you control their hours of work, where they work, and how they perform the job. This person is an employee.
- Statutory employee: If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social Security and Medicare taxes:
- A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done
- A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson's principal business activity.
You should consider whether 3 (1) above includes a person who does your typing or research at home or elsewhere. Does it include a candle-stick maker who works from their garage for you or a baker who works from their kitchen for you?
Withhold Social Security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:
1. The service contract states or implies that substantially all the services are to be performed personally by them.
2. They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities.)
3. The services are performed on a continuing basis for the same payer.
- Statutory nonemployee: There are three categories of statutory nonemployees: direct sellers, licensed real estate agents and certain companion sitters. Direct sellers and licensed real estate agents are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
- Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked; and
- Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
Now you may ask: "Why should I care?" You might think, "my employee/independent contractor will not turn me in as they are not paying taxes anyway and we are in a friendly relationship." Have you heard of whistle blower statutes? One of the biggest causes of IRS audits is from disgruntled associates, employees, and ex-spouses. The IRS Whistleblower–Informant Award program offers rewards of 15-30% of the amount collected. The first award in 2011 was four and one half million dollars ($4,500,000.00) to an anonymous accountant.
What if you have been paying the person “under the table?" Unless you are not reporting income you receive, then you are claiming income but not deducting the valid tax deductions for earning that income. If you are not reporting the income then you are incurring additional liabilities including possible criminal penalties.
What happens if the person gets injured and files for worker’s compensation and/or social security disability and you have not reported them as an employee? For social security disability, the person must have paid in for a certain period of time. If they were not paying the taxes and it was determined you should have been paying the taxes, then you are subject to tax penalties. Can you then be sued for the benefits they would have received? You can be liable for all the unpaid taxes, even if you are not the owner of the company. See Who Can Be Responsible for the TFRP. These taxes may not even be dischargeable in bankruptcy and may be withheld from your income, wages, and tax refunds in the future.
Next, if the person files a worker’s compensation claim and is determined to be an employee for who you have not carried worker’s compensation insurance, what can happen? Pursuant to I.C. 22-3-4-13(f), “In an action before the board against an employer who at the time of the injury to or occupational disease of an employee had failed to comply with IC 22-3-5-1, IC 22-3-7-34(b), or IC 22-3-7-34(c), the board may award to the employee or the dependents of a deceased employee:
- compensation not to exceed double the compensation provided by this article;
- medical expenses; and
- reasonable attorney fees in addition to the compensation and medical expenses.”
So, this means if your secretary gets in a car accident when delivering mail to the local post office and you do not have worker’s compensation insurance her health insurance (if he/she has it) may not cover her/him as he/she is working (see our previous blog on worker’s compensation), and you can be held liable for the entire medical expenses, attorney fees and up to double what the worker’s compensation awards would be.
Now you have a disgruntled employee who may have to file bankruptcy to discharge medical bills, has no income and does not qualify for social security disability. Do you think this person may sue you under Title 22 above? Do you think this person will turn you in to the IRS?
In my practice I regularly encounter people who think they are saving money by claiming everyone who works for them are independent contractors and as such do not pay withholding taxes, worker’s compensation insurance, and sometimes do not issue 1099’s. I have not even addressed the state tax penalties, overtime laws, or the additional IRS penalties for failure to file returns or pay taxes, interest on the taxes/penalties, implications of hiring a contractor who does not cover their employees for worker’s compensation and the interest on all of these Suffice it to say, not treating an employee as an employee is a dangerous practice. It is even more dangerous if you pay them under the table and do not report income. You should consult a Certified Public Accountant or your business attorney to see what advice they will give you. You may not like the advice but in the long run you may be able to sleep at night without the worries of the possible repercussions.
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