How to Classify Workers on Taxes

Did you know that how employees are classifieds hold serious tax implications with the IRS? Did you know that the IRS checks to see if workers are properly classified? Some employers incorrectly classify their workers as independent contractors to avoid paying payroll taxes knowing they should pay workers as employees. This is a practice to be avoided.

During tax audits of businesses, the IRS will look at how workers are treated to determine if the guidelines are being followed. Not following the guidelines means significantly high penalties.

It is important to know how the IRS defines an independent contractor versus an employee. Generally, anyone who offers the same service that your firm offers should be considered an employee. For example, if you have a retail store and have employees who run a cash register and help customers, they should be classified as employees. It’s about behavioral control and financial control. Even if your workers agree to be treated as independent contractors and take responsibility for their own taxes, the IRS will reclassify them as employees and penalize you for not following the rules.

If a bookkeeper is employed to assist with bookkeeping needs from her office via telephone and internet, using her own supplies and computer, and if that person also has a string of other clients, a business license, insurance, or a contract with you, there is no question that they are an independent contractor. However, if you employ that person, tell them to be at your office at a certain time, use your equipment, your phone, your desk, your break times then that person is an employee. That person needs to be paid as an employee.

You own a day spa and you hire a masseuse to work on call. The masseuse has her own business and a set of clients, a business license, and insurance. You agree to a payment of a percentage of completed massages. Sounds like an independent contractor, right? The answer is no. The masseuse offers the same service that your business offers, so they should be treated as an employee.

Recently, the voluntary classification settlement program (VCSP) was set up to provide taxpayers with an opportunity to reclassify workers as employees for future tax periods for employment tax purposes. Employers will enjoy some relief from federal employment taxes if they come into compliance. According to the IRS, “to participate in this new voluntary program, the taxpayer must meet certain eligibility requirements,” apply to participate in the VCSP by filing form 8952, Application for voluntary classification Settlement Program, and enter into a closing agreement with the IRS.

If you are under an income tax audit, not an employment tax audit, and you may feel that the auditor may be scrutinizing outside services or subcontractor expense categories and questioning whether your 1099 recipients should really be classified as employees. This would be a good opportunity to enter the VCSP.

If you are eligible for the VCSP you will be required to pay 10% of the employment tax liability that would have been due on current year compensation determined at reduced rates listed in the IRS Tax Code, section 3509 (a). In return, the IRS promises not to perform employment tax audits for prior years and you will not be required to pay penalties and interest.

A pretty good deal if you feel you might be crossing the line!

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