Tax Savvy for Small Businesses:

Tax Concerns of Employers

“If there isn’t a law, there will be.”

—Harold Farber

Chances are if your venture is successful, you won’t be able to do all the work yourself. If you can do it all on your lonesome, don’t worry about this chapter. But being an employer carries a whole new set of tax responsibilities. Once you have employees, the IRS will be looking over your shoulder to see if you are filing payroll tax returns and making required tax deposits.

If your business uses independent contractors instead of employees, you can avoid payroll taxes and hassles of paperwork. However, the IRS may audit to see if anyone you call an “independent contractor” rather than an “employee” is classified correctly. If you lose, the consequences can be very expensive, as we shall see.

Every employer has an obligation to:

• withhold payroll taxes from employees’ wages

• remit these taxes, together with the business share of employment taxes, to the IRS, and

• make periodic employment tax reports to the IRS (IRC § 3509)

According to the IRS, the majority of small businesses fall behind in filing reports or making federal tax deposits at one time or another. (I have to confess that my office missed getting an employment tax form filed on time on at least one occasion.) While many of these delinquencies are oversights—like missing a deadline—others reflect poor office management or poor understanding of employer tax obligations.

It is tempting, in a “cash crunch,” to pay rent, utilities and key suppliers instead of making a payroll tax deposit. Folks rationalize that since it takes the IRS months (if not years) to find out, employment taxes can wait. Too often, however, the business keeps struggling or goes under altogether, but the tax obligation survives.

Under all circumstances, pay your payroll taxes, in full and on time. If you don’t, the IRS will knock at the door, and when it does, it won’t be gentle. The IRS tacks on interest and penalties to delinquent payroll taxes. The bill can skyrocket so fast that often, businesses fail as a result. And unlike ordinary debts, payroll taxes survive the death of the owner or bankruptcy of the enterprise. Payroll taxes, by law, are personal liabilities of business owner(s) or their heirs. (IRC § 6502.)

Employer Tax Concerns in a Nutshell

1. If your business has employees, you must withhold taxes and file payroll tax reports.

2. IRS auditors are on the alert for businesses that misclassify employees as independent contractors, and they can levy heavy penalties on violators.

3. Business owners, and sometimes employees, too, can be held personally liable for unpaid payroll taxes of the business. (You may, however, appeal IRS findings of responsibility.)

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A. Payroll Taxes

The term “payroll taxes” covers three different types of taxes that every employer is responsible for:

• Income tax withheld from each employee’s paycheck throughout the year. You must send an IRS W-2 form to each employee showing all payments and all withholdings from their wages. W-2 forms must be furnished by January 31 of each following year. By February 28, you must also file IRS Form W-3 (summary and transmittal form) and copies of all the W-2s to the Social Security Administration, which transmits the data to the IRS.

• Social Security and Medicare tax (FICA). The employee’s share is withheld from each paycheck; the employer must match this amount. The total FICA tax rate is 15.3% of wages paid up to $84,900 (2002). All income over this amount is taxed at 2.9% for Medicare.

• Federal Unemployment Tax (FUTA). This tax goes to the unemployment insurance system and must be paid by the employer. The employee pays no part of FUTA.

How to figure tax withholding for employees is shown in IRS Publications 15 and 15-A, Circular E, Employers’ Tax Guide. Form W-4 (Employees’ Withholding Allowance Certificate) helps an employer determine how much to withhold from employees’ paychecks for federal income tax purposes. One look at Circular E, however, might convince you to hire a payroll tax service or get your accountant to do the forms for you—at least the first time around.

Generally, each employee’s withheld income and FICA taxes are paid to the IRS monthly, by making federal tax deposits at specified banks. (If the total owed is $2,500 or less, the deposits are due quarterly.) An IRS Federal Tax Deposit coupon (Form 8109-B) must be submitted with each payroll tax payment. If your total annual payroll tax obligation exceeds $200,000, you must make electronic deposits. Call the IRS at 800-555-4477 or 800-945-8400 for details, and see IRS Publication 966.

In turn, these payments are reported to the IRS on Form 941, Employer’s Quarterly Federal Tax Return. This form is due one month after the end of each calendar quarter that you have employees. Form 941 shows how many employees you had, how much you paid them and the amount of Social Security, Medicare and federal income tax withheld during the three-month period. (A sample Form 941 follows.) Alternatively, you can file Form 941 TeleFile by using a touchtone phone. Call the IRS at 800-829-1040 or go to the IRS’s website at http://www.irs.gov for details.

There is also an annual unemployment tax report detailing FUTA taxes due (Forms 940 or 940EZ). This form shows how much federal unemployment tax is owed. A credit is allowed for any state unemployment taxes paid. (You don’t get any credit unless you paid the state unemployment tax on time.) FUTA is 100% paid by the employer; there is no contribution or deduction from the employee’s wages.

Payroll tax obligations are based on a “trust fund” theory. The employer initially acts as a tax collector by holding employees’ taxes in trust until paid to the IRS. Violation of this trust can bring on both civil and criminal punishments to the employer. Although the IRS seldom throws anyone in jail, it can—and often does—seize a business’s assets and force it to close down if it owes back payroll taxes.

Most states that tax income also require employers to withhold employees’ taxes similar to the federal law. Some cities, such as New York City, have payroll taxes, too.

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B. Employee or Independent Contractor?

Individuals who perform services for your small business are usually classified as either regular employees (legally termed “common law employees”) or independent contractors (usually meaning they are “self-employed” for tax purposes).

A small percentage of people may fall into two other categories recognized by the IRS: “statutory employees” and “statutory non-employees.” We’ll talk about all of these categories of workers in more detail below.

It may not make much difference to you how someone is classified, as long as the work gets done. The distinctions, however, are very important to the IRS, and can be very costly if you don’t pay attention to them. Let me warn you: the law is muddled here, and legal experts regularly disagree as to whether someone is an employee or an independent contractor.

Congressional Dithering

In recent sessions, Congress has repeatedly failed to pass bills which would have greatly simplified the question of just who is an employee and who isn’t. Sooner or later, Congress will again try for clarification—we hope.

If you have been with me since the beginning of this chapter, you realize that you have payroll tax withholding and reporting obligations for all of your employees. You report your employees to the IRS on quarterly 941 forms and W-2 forms issued annually.

On the other hand, with a true independent contractor, you don’t have any withholding or contributions for payroll taxes, and your only duty to the IRS is to issue a 1099 form once a year to each worker. (There are 11 versions of the 1099 form; the “1099-Misc.” is the one issued to an independent contractor.) And you don’t have to make any report to the IRS at all if you pay the independent contractor less than $600 a year, or the services were performed for you personally and not for your business or if the service provider was incorporated.

The employee/independent contractor determination is crucial. The most important advice in this book might turn out to be this: Always make a determination (hopefully, a correct one) of whether or not the person you hire is an employee or independent contractor before the work begins.

Calling someone an independent contractor is very advantageous to a business—it saves a lot of time that would otherwise be spent on complying with IRS reporting requirements. Even more significant, you won’t have to make the employer’s share of the FICA contributions for each worker; this saves you 7.65% (2002) of each paycheck. You won’t have to pay unemployment compensation tax, either. But you should realize that the IRS is very aware of the benefits of misclassifying an employee as an independent contractor, and has wide powers to make life miserable for all those it catches doing it.

Business Owners. Sole proprietors, limited liability company members and partners are neither employees nor independent contractors. These folks are owners, so are not subject to payroll tax withholding and paying. They should pay and file quarterly Estimated Taxes instead. This amounts to about the same amount of tax being paid, but with a lot less accounting and IRS paperwork required. However, small business shareholders/owners of corporations—C or S type—who work for the corporation are employees and subject to payroll tax rules.

No other classifications of workers are recognized by the IRS. Many employers mistakenly believe that a short-term worker is not an employee. Sorry, whether part-time or temporary, called a consultant or subcontractor, a worker must fit into one of the four categories discussed below for tax reporting purposes.

1. Common Law Employees

Anyone who performs services that can be controlled by an employer (what work will be done and how it will be done) is termed a “common law employee” or just plain “employee.” Even if an employer doesn’t actually exercise control, but gives the worker freedom of action, she is the employee. As long as an employer has the legal right to control the method and result of the work done, there’s an employer-employee relationship. Under this definition, most working people who do not own their businesses are common law employees.

Here are more factors the IRS says that show a worker is a common law employee:

1. The worker can be required to comply with instructions about when, where and how to work.

2. The worker is trained by the employer to perform services in a particular manner.

3. The worker’s services are integrated into the business operation, or a continuing relationship exists.

4. The worker is required to render services personally.

5. Assistants to the worker are hired by the business, not the worker.

6. The worker has set hours of work.

7. The worker is required to devote substantially full time to the employer.

8. Work is done on business premises.

9. The worker is required to submit reports regularly.

10. The worker is paid by the hour, the week or month, unless these are installments of a lump sum amount agreed for the job.

11. The business pays the worker’s business or travel expenses.

12. The business furnishes tools, equipment and materials.

13. The business has the right to fire, and the worker has the right to quit at will.

2. Independent Contractors

The IRS says that people in business for themselves —not subject to control by those who pay them—are independent contractors, not employees. When you hire an independent contractor to accomplish a task for your business, you don’t have an employer-employee relationship and don’t, therefore, have to pay employment taxes. Independent contractors (ICs) are responsible for their own tax reporting and are treated as business owners themselves.

The IRS says these factors tend to show a person is an independent contractor:

1. The worker hires, supervises and pays her assistants.

2. The worker is free to work when and for whom she wants.

3. The work is done on the worker’s premises.

4. The worker is paid by the job or on straight commission.

5. The worker has the risk of profit or loss.

6. The worker does work for several businesses at one time.

7. The worker’s services are available to the general public.

8. The worker can’t be fired except for breach of contract.

Protect yourself from potential IRS claims that you misclassified employees as independent contractors. As a business owner, any independent contractor you hire should be:

• paid by the job, not by the hour.

• working on his or her premises only, if possible.

• showing you a business license and workers’ compensation insurance coverage (if applicable).

• signing a contract spelling out the terms of the work relationship. (See “Contracts With Independent Contractors,” below.)

Contracts With Independent Contractors

If an IRS auditor attempts to reclassify a worker from independent contractor (IC) to employee, a written contract with the IC may sway the auditor. A signed contract won’t help if the worker in question is obviously an employee, but it can be persuasive in borderline situations. A written agreement with an independent contractor should acknowledge that he or she is an IC, spelling out his or her responsibilities. (Pay attention to the IRS list of factors.) Include a clause stating that all payments to the IC will be reported to the IRS on Form 1099. If you will be using any independent contractors, develop blank contract forms and have each IC sign one before they start performing any services.

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C. Recordkeeping Requirements on Service Providers

You must keep records on most folks—whether employees or independent contractors—who provided services to your business. The IRS and state tax agencies can demand to see these records as part of a regular audit or a special employment tax audit. Normally, the minimum amount of time to keep these records is three years, but six years is advisable for having these records handy. Basic employer records should show:

• Employer Identification Number document issued by IRS

• amounts and dates of wage and pension payments to workers

• names, addresses, Social Security numbers, occupations, dates of employment for everyone paid for their services

• fringe benefits and goods or services provided in addition to cash to workers

• employee tips reported (if applicable)

• Forms W-2 and 1099 showing payments to workers, including any that were returned by the post office as undeliverable

• income tax withholding certificates completed by each worker (Forms W-4)

• federal and state payroll tax deposit forms with dates and proof of payment (deposit slip, canceled check or financial institution receipt)

• federal Forms 940 (annual) and 941 (quarterly) and corresponding state payroll tax forms

• income tax returns of yours or the business entity on which payments to workers were claimed, and

• FICA (Social Security & Medicare) and FUTA (unemployment) taxes paid for each worker.

For details on these and other employer recordkeeping requirements, see IRS Publication 15, Circular E. As with most IRS forms, it is available at IRS offices by calling 800-829-3676 and on the Internet at http://www.irs.ustreas.gov.

Excerpted from “Tax Savvy for Small Business”, by Frederick W. Daily