Under the 1935 National Labor Relations Act (NLRA), also known as the "Wagner Act" (named for the late New York Senator who was its chief congressional sponsor), for purposes of federal labor law, an "employee" is any person earning wages, salaries or commissions, not including farm workers, domestic servants, people working for their spouse or parent, railroad employees (covered by their own law) and independent contractors.
The Wagner Act was the first national law declaring the rights of workers to organize and join labor unions, bargain collectively and to have protection against certain employer actions defined as "unfair labor practices." As important as the NLRA is, its interpretation of an "employee" is not the most important definition when it comes to defining an independent contractor for tax purposes.
Far more important, the Internal Revenue Service expansively defines "employee" in section 3121(d)(2) of the Internal Revenue Code as any individual who under, "the usual common law rules applicable" to employers and workers "has the status of employee." If that sounds highly open-ended, it is. There are no formal "common law rules," and the phrase itself refers to the mass of individual court and executive branch decisions handed down over many years in case rulings involving employees. As you will see, the IRS prefers that all workers be considered "employees" rather than independent contractors because it makes income tax collecting a lot easier for them.
In evaluating the facts of each case, the IRS uses a list of twenty factors or criteria to judge whether a given worker is an "employee" or an "independent contractor." A violation of any one of these highly subjective rules allows the IRS to reclassify a worker from the status of independent contractor to that of employee.
The essential test is whether management has the right to supervise and control the manner and means of work done by an individual. The employer need not actually exercise this power; it is enough that he or she has the right to do so. If so, the IRS says the worker is an "employee." If a worker clearly controls his or her own work methods, works for multiple employers, sets his own hours, is liable to suffer loses or make a profit and provides his or her own equipment, the IRS will usually concede this person to be an independent contractor.
On the other hand, an "employee" usually must comply with the boss's instructions, renders personal service, works at his employer's place of business and uses tools or equipment the employer provides. He also can be fired or quit at any time. Another difference: an injured "employee" is covered by statutory workman's compensation laws, but an "independent contractor" is not.
A true independent contractor controls his or her own hours worked and is paid when a product is finished, not by an hourly wage. The client cannot dictate how a contractor reaches a final result and his only legitimate concern is the quality and timeliness of the product. The independent needs more than just one client. Working 90 percent of the time for a former employer is sure to support an IRS finding of an employment relationship.
The independent must have home or other office removed from an employer's business premises and pay for his or her own office supplies and equipment. A written contract covering all these points is essential and may be accomplished by a simple "letter of agreement" outlining the product to be delivered, the due date, and the fee to be paid by the client.
The IRS assumes certain designated types of workers are independent contractors (professionals like doctors, lawyers, engineers, accountants, architects, consultants, real estate agents, direct sales persons, and some artisans like carpenters and plumbers), while most other workers are presumed to be employees.
The IRS automatically classifies certain other types of workers as employees under a "statutory" definition, including drivers who distribute goods and services such as meats, vegetables, bakery goods, beverages, laundry and dry cleaning; also full-time insurance sales people, home workers who perform work according to an employer's exact specifications, and full- time traveling sales people.
For example, today's "temporary workers," now a very important labor phenomenon, are independent contractors in relation to the work places where they are assigned to work, although they may be employees of their "temp" company, depending on the terms of their contract.
Unfortunately, in an amendment contained in Section 1706 of the Tax Reform Act of 1986, Congress said in effect that technical workers contracted for through a third party broker, such as engineers and computer programmers, cannot be treated as independent contractors. This section of the law has caused massive confusion and badly hurt technical consulting companies and smaller businesses who want part time assistance of this nature. Congressional legislation to correct this problem is now being considered.
An Important Distinction
The distinction between these two worker groups is important because the status of a worker defines his or her rights and remedies in various situations, including, most importantly for the IRS, whose obligation it is to pay unemployment, income withholding and Social Security taxes. An independent contractor is responsible for filing and paying his or her own taxes, whereas the employer must do this on behalf of an employee.Because tax revenue is at stake, the IRS constantly checks business firms to see whether workers listed as independent contractors should really be treated as employees. The tax treatment of the two groups is quite different. The IRS prefers to collect taxes on employees from companies because employers are seen as more efficient and reliable taxpayers and easier to control, compared to independent contractors who are on their own and virtually unchecked (and uncheckable) by the IRS.
Rather than trying to reclassify millions of independent contractors one by one, the IRS takes the easier route of attacking the employment status of workers for the thousands of companies who employ independent contractors.
From 1988 to 1994, the IRS conducted 11,400 audits of firms forcing the reclassification of nearly 500,000 as employees rather than independent contractors, producing an additional $751 million in payroll taxes and penalties. Studies show that IRS rulings support "employee" status 90 percent of the time. The IRS is no respecter of size. Audits range from International Business Machines, Inc. (IBM), right down to the "mom and pop" enterprises.
Special targets have been truckers, florists, travel agents, computer programmers and even ministers of the faith.
Here's some 1995 cases reported in the media: Texas A&M College admitted it had paid 400 farm workers as independent contractors when they were in reality employees. The college was socked with $86,000 in back taxes. A New York City travel agency, Pisa Brothers Travel, had to pay $274,000 after agents were ruled to be workers. Paddock Publications, Inc. of Arlington Heights, Ill. is fighting a $5.6 million retroactive assessment based on reclassification of 1,500 newspaper employees including delivery men. That amount includes a $1 million fine. The company, operating on a small profit margin, says it will have to file bankruptcy if the IRS persists.
According to the Wall Street Journal, "Small companies are bearing the brunt of the IRS crackdown because they frequently fail to report free-lance employees, which encourages [these independent] contractors to conceal income." The IRS claims rather grandly that tax-evading independent contractors owed the government $30 billion for the 1993 tax year alone, but that estimate is disputed by outside experts.
Businesses suddenly found to have retroactive liability for "employees" treated as independent contractors face enormous dollar amounts for withholding, Social Security and other taxes, sometimes going back for many years. In IBM's case, as far back as 1986.
Taxes and the Independent Contractor
Whatever the tax problems faced by employers who hire "independent contractors," for the independent contractor himself his status does reduces taxes indirectly because of the ability to deduct from gross income all legitimate business expenses including personal and fringe benefits.Of great importance, you should know that an independent contractor doing business as a corporation stands the lowest risk of being audited by the IRS. The major reason for this interesting statistic we explained a moment ago; the IRS is much more likely to audit a payor firm where it has the possibility of reclassifying as "employees" a large number of workers supposedly operating as "independent contractors." That approach gives the IRS lots of back taxes and penalties. An audit at the level of the payee/worker would catch only one worker in reclassification, a waste of time and energy from the IRS viewpoint.
Independent contractors, however, must pay ordinary income taxes, Federal Unemployment Tax Act (FUTA) taxes, and Social Security taxes in the form of the self-employment "Federal Insurance Contributions Act" (FICA) tax, which is about 2 to 3 percent less than the FICA tax a company employer would have to pay for an employee. (When a company pays FICA tax, part is borne by the company and part is deducted from the employee's wages.) Self-employed independent contractors also must estimate their individual income taxes for each year, then pay a quarter of the estimated amount owed to the federal and state governments each calendar quarter. Failure to pay or late payment means hefty penalties and interest added.
Independent contractors receive a Form 1099 at the end of the year. Like the W2, this form reports to the IRS the amounts paid, but in the case of the report on 1099 there is no tax withheld.
Form 1099 is required for payments over $600 per year, to individuals, partnerships, and other unincorporated entities. Certainly, receiving only one Form 1099 would bolster an IRS argument that an individual was an employee rather than an independent contractor -- so it is important to develop a variety of income sources (in addition to the good business sense of diversifying one's income).
There is no Form 1099 filed for payments to corporations, and as a practical matter this helps the incorporated independent contractor step aside from the entire independent contractor vs. employee debate. A corporation, by definition, cannot be an employee. And the fact that no Form 1099 even appears in the IRS computer next to the individual's name keeps one from even being swept into a random sampling of independent contractors for audit.
Becoming an Independent Contractor
If you structure your job properly you can convert an employer into a client and get paid more money for doing the same job as an independent contractor rather than an employee.Once a worker converts to independent contractor status, the former employer no longer has a legal obligation to withhold and pay income, Social Security and unemployment taxes or workman's compensation benefits. This frees the company from the bookkeeping headaches of calculating, deducting and forwarding tax payments to the government, of processing paperwork for health and life insurance and of providing supplies and equipment.
Since a company can realize major savings under this new arrangement, a newly independent contractor should be able to negotiate increased pay benefits from some of those savings. Take into account the value of benefits such as sick leave, employee discounts, and health, disability, and life insurance.
This option should not be dismissed as some wild dream reserved for mavericks. Thousands more "mainstream" workers follow this new work route each year. House painters, floor layers, researchers, writers, custom seamstresses, management experts, engineers, carpenters, electricians, insurance claims processors, bookkeepers, and those in many other occupations successfully turn themselves into independent private contractors.
If you choose to operate as an unincorporated business, the "sole proprietorship" we have already discussed, you must pay all business expenses yourself, many of which may not be deductible against your personal income tax liability. The self-employment Social Security tax takes a big bite and is not deductible for an unincorporated business.
Top Ten Problems with a Home Office
If you don't incorporate and you do work at home, you may be able to benefit from the "home office" deduction, but the IRS is strict in applying rules as to what qualifies for a deduction in such cases. It became even more difficult to benefit from the home office deduction after a 1994 U.S. Supreme Court ruling that greatly tightened the definition of a "home office" for tax purposes.The case involved a suburban Washington, D.C. anesthesiologist who worked at several hospitals but whose only "office" was at home where he did all his paperwork and billing. The Court held that the doctor's one room home office didn't qualify for a home office deduction because most of the time he was working elsewhere rather than at home. Prior to this unwelcome ruling, expenses related to the use of a home office would have been generally deductible against business income if the business owner had no other office and worked a substantial part of his or her time there.
Under the new rules the IRS says a home office qualifies only if it is used exclusively for business. If the kids watch TV in the same room, it's not an office for tax purposes. The IRS also makes a distinction about what constitutes a "principal office." For example, the IRS says a salesman who spends most of his time on the road visiting customers does meet their test of "substantial" use of his home as a "principal office." On the other hand, if the a person rarely ventures away from his home office and conducts his business by phone, mail and E-mail, the IRS says that's a bona fide home office.
Legislation now pending in Congress seeks to broaden the definition of a home office and remove inequities and confusion. These proposals would allow business owners who do most of their work outside their home, such as plumbers or salesmen, to claim the deduction so long as their home office serves as their business headquarters.
Since 1991 individuals claiming a home office have been required to fill out and file with their income tax a separate IRS Form 8829. About 1.5 million such forms are filed each year.
If your home office does qualify for IRS purposes, you can deduct costs of your home mortgage interest or rent, real estate taxes, insurance, home improvements and repairs that contribute to the upkeep of the office such as installing a home security system or fixing a heating or air conditioning system. One can also depreciate the part of a home used as an office. Expenses must be apportioned in percentages between home and office portions of the house, using an IRS square footage test.
If your home office expenses exceed your business income, you can carry forward the loss to next year's business income. Like every thing else involving the IRS, it is absolutely necessary to keep detailed records to support your deductions, especially is they challenge your home office status.
Wealth from Tax Deductions
One area of finance you will need to know about, in addition to building business equity, is how to create business wealth by deducting from taxable income legitimate business expenses, thereby reducing potential income tax liability and increasing profits.Generally speaking, you can:
- convert your "personal" expenses into business tax- deductions;
- divide business income among several family members to avoid the full impact of progressive income tax rates on one individual;
- have your business compensate you with tax-free benefits in lieu of a larger, taxable personal salary;
- deduct vacation and travel costs under certain conditions;
- write off as a corporate business expenses the costs of establishing and operating your home office.
Conducting your own business as a corporation allows tax deductibility for many goods and services your company purchases, things you might otherwise purchase yourself using your own personal income. Goods and services you once were forced to buy with your own after-tax dollars suddenly become deductible expenses, in effect tax-free fringe benefits the business provides for its employees -- even if that's only you. One person corporations are permitted in almost every state; you need no other employees to take advantage of these tax breaks yourself.
Whether you have one or several employees, the federal tax treatment of corporate employee benefits is another advantage of incorporating your business. IRS rules recognize two general types of employee fringe benefits, those special benefits provided specifically for one employee, or those broader categories of benefits equally available to all workers within a given class.
Special Benefits
Among the specific benefits the law allows tax-free for employees that are tax-deductible as a business expense for a corporate employer are:
- Group accident and health insurance plans
- Group-term life insurance up to $50,000
- Group prepaid legal services
- Cafeteria or flexible-benefit meal plans
- Van-pooling transportation arrangements
- Scholarships and fellowships for training
- Dependent care assistance for workers with children
- Educational assistance related to an employee's job
General Benefits
Provision of health and medical insurance for employees offers a good example of the kinds of advantages that flow from incorporating your own business.Once a worker no longer has group coverage available, an employee who leaves a larger company to start his or her own business often is shocked by the high-cost of individual health insurance premiums necessary to obtain comparable protection. A family plan with comprehensive coverage and dental benefits can cost an individual outside a group as much as $400 a month or more. But when that individual incorporates his own business, the new company can purchase health insurance and deduct the cost as a business expense.
What's even better for the recipient, health insurance benefits do not count as income for individual income tax purposes. The only major restriction on corporate health care insurance plans is that benefits must be equally available to all employees within certain groups as defined by IRS regulations.
Special health insurance or other company benefits are considered taxable income if availability is restricted only to officers or other highly compensated employees. This rule does not present a problem to a one-employee corporation, but benefit plans must be drafted so that future permanent full-time employees will be eligible for the same benefits.
Life insurance protection, tax-free for the covered employee and tax-deductible for the company, is another great benefit made possible by operating as a corporation. When a company creates a group term life insurance plan, covered employees receive the first $50,000 of coverage tax-free. The percentage of the company-paid life insurance premium for more than $50,000 of coverage is reportable as ordinary income by the insured worker, an amount determined by IRS tables taking into account age, years of service, compensation, and the employee's position in the company. The employer must be the owner of record of the insurance policy to qualify for deductibility.
One drawback is that life insurance coverage usually ends at an employee's retirement, although some retired persons need and want continued insurance which can be very costly if paid for by retired employees themselves.
A corporation has the ability to offer employees many other tax-free benefits, all cost-deductible for the company. For example, if an employer does not incur a substantial cost including lost revenue providing certain benefits, they can be given to workers tax-free, as when the boss allows waiters and other help to have free meals at a restaurant. As a general rule, to qualify as tax-free, such add-on employee benefits must be of the same nature the business provides to the public.
Qualified employee merchandise discounts are tax-free when they don't exceed the employer's gross profit margin on the product, or are more than 20 percent of the price charged to other customers.
Also among "fringe benefits," a business can provide certain goods or services tax-free that otherwise would be deductible trade or business expenses for the employee if he or she personally paid for them. Free parking for employees' motor vehicles on or near the business premises is considered such a fringe benefit. The employer can deduct the value of the parking provided, and the employee needn't count that value as taxable personal income.
Certain fringe benefits are tax-free if their value is so small ("de minimis") that accounting for them is unreasonable or impractical. Typing a personal letter on company time, company cocktail parties, picnics, and holiday gifts are all unreportable "de minimis" fringe benefits. For example, employee personal use of a copying machine is tax-free if the employer shows that 85 percent of the machine's use is for business.
About the Author Adam Starchild is the author of many books and articles on tax planning, home businesses, and personal finance. The above article is reprinted with permission from his book How to Save on Your Taxes Without Cheating.
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