Independent Contractors or Employees - How You Classify Is Important

Congratulations on the growth of your new business. Using independent contractors is a good way to handle temporary or seasonal peaks of business, and to assess workers for suitability for full-time employment. This practice also saves the costs of payroll taxes, employee benefits, and worker's compensation insurance. But, just because you say they are independent contractors, does not make them so.

The Internal Revenue Service provides guidance to help you assess whether you have hired an employee or independent contractor. The differences lie generally in your level of control over the work being performed.

Employees are subject to a higher level of control, training, and supervision. You provide their work location, set their hours, supervise their work, have the right to discharge them, and maybe provide some employee benefits. They receive wages which are subject to Federal and state withholdings, as well as Social Security and Medicare taxes. As the business owner, you are liable for the employer's portion of Social Security and Medicare taxes, unemployment taxes, and, under certain circumstances, worker's compensation insurance.

Independent contractors are not subject to that same level of control. Characteristics of an independent contractor include:

*Work for other businesses and make their services available to general public

*Set their own hours and order or sequence of work

*Paid by the job and use a contract for services

*Have a substantial investment in the trade or business

*Bear risk of economic loss

*Have opportunity for profit or loss

*Provide tools and materials necessary to complete assignments

*Hire and fire their own assistants

There are also different reporting requirements. When you hire an employee, you are required to have them complete Form W-4 for Federal withholdings, Form NJ-W4 for New Jersey withholdings, and Form I-9, "Employment Eligibility Verification." An independent contractor completes Form W-9, providing their name and address information, form of doing business, and Taxpayer Identification Number. New Jersey now requires them to also provide proof of business registration.

At the end of the year, prepare Form W-2 to report employee wages earned, certain employee benefits, and taxes withheld. Other forms and tasks are required periodically during the year. For independent contractors you paid more than $600 during the year, report total payments on Form 1099-MISC.

Tax and technical aspects aren't the only considerations in your decision whether to hire employees or independent contractors. You're building a business, so developing employee loyalty should be an important consideration. Loyal employees help create repeat customers, and provide expertise and manpower to help you manage and expand your operations. Independent contractors can perform certain tasks more efficiently due to their expertise. For example, a virtual assistant can tackle certain administrative or marketing functions, and free you for the more important of task of handling client development.

If you think you've inadvertently misclassified a worker as an independent contractor, your CPA can advise you the steps to take. Under IRS guidance in Section 530, you may have a "reasonable basis" for not treating the worker as an employee, if you reasonably relied on:

*Judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;

*Past IRS audits, if there were no penalties assessed for similar treatment of individuals, and the audit included a review of employment records.

*Long-standing, recognized practice of the industry.

If you intentionally misclassified workers to prevent paying the payroll taxes, you may be subject to substantial penalties.

Classification of workers can be complicated, so if you aren't sure which category is correct, contact your CPA and discuss your situation.

Hope Player started her own CPA firm in Roanoke, Virginia, in 1987. She promotes small business by helping start-up companies, and speaking at national, state, and local meetings on various topics relating to entrepreneurship. Hope is currently the Managing Member of The Arcadian Group, LLC, a CPA firm in New Jersey which provides accounting, consulting, and tax services to businesses, individuals, and nonprofit organizations. http://www.thearcadiangroupcpa.com