What’s at Stake in Defining an ‘Independent Contractor’ for Tax Purposes
Misclassifying an employee as a self-employed worker can result in harsh consequences. Business owners can protect themselves from audits and tax penalties by understanding and adhering to specific reporting criteria.
Many installing security and systems integration companies classify their employees as independent contractors. Some arguments can be made to support this reasoning, especially for technicians and salespeople. The work they do requires certain skillsets and in turn their compensation may be based upon performance results.
Some companies may even attempt to “hybridize” these employees by paying them a base salary and issuing a W-2 form, as well as paying them a bonus that is then reported on a Form 1099.
As all employers understand, payroll taxes have three components: estimated employee income tax (withholding), the employee’s portion of FICA tax (Social Security and Medicare), and an employer match of half of the employee’s FICA tax. The first two items are generally withheld from the employee’s paycheck and the third item is paid by the employer.
While an employer is liable for paying its half of the FICA tax, the other two items are deducted from the employee’s pay and remitted to the IRS. An independent contractor is responsible for paying taxes on its net income and for paying the entire amount of the FICA tax (self-employment tax). Let’s take a closer look at the conditions and regulations that govern the worker status of your employees.
Taking Note of the Payroll Tax Compliance Audit
If given the opportunity, most employers would prefer their workers be classified as independent contractors. Doing so saves them half of the FICA expense and relieves them from the duty of preparing and filing the employment tax paperwork. Many employers also believe the self-employed classification affords them an advantage since the independent contractor’s net pay is higher and the individual is responsible for all taxes. Many employers also prefer classifying workers as independent contractors in order to avoid state unemployment and worker’s compensation issues.
As you may have guessed, the taxing authorities do not agree with employers’ position on this matter. Hence, the IRS has used one of its most powerful tools — the audit — to ensure compliance. Notably, payroll tax compliance audits are different than income tax compliance audits. The former are very focused, straightforward for the inspector to conduct and yet can be potentially devastating for the taxpayer under scrutiny.
Additionally, income tax compliance audits almost always include a payroll tax compliance audit. Along with the IRS, state and local authorities are also interested in proper classification of employees for the purpose of unemployment compensation insurance, as well as state tax income tax compliance. The IRS and state authorities now commonly work in partnership, which means that an unemployment insurance claim filed by a former “contractor” could very easily result in an IRS payroll tax compliance audit.
The general rule for differentiating between independent contractors and employees is “method and output.” If the employer controls the method of the work or how the work is done, the worker is most likely an employee. If the employer controls only the output, then the worker may be a contractor.
Consider this analogy to help clarify the differentiation: If you contract with a painter to paint a wall a certain color by a certain date, and he supplies the paint, ladders, drop cloths, helpers, etc., you are only controlling the output and the painter is probably a contractor. If you supply the paint, ladders, drop cloths and helpers, plus instruct the painter to work from 8 a.m. to noon, then take a break and return to the job at 1 p.m., you are controlling the method and the painter is probably an employee.
You Might Think ‘Self-Employed’ but Tax Boards May Not Agree
IRS auditors use a 20-point test to determine a worker’s proper classification. In addition to control, it includes items such as training, right to fire, extent of personal services, continuity of relationship, flexibility of schedule, sequence of work, provision of tools and materials, and work for multiple companies, among other factors. Before assuming a worker is an independent contractor, you should consider the consequences of misclassification.
If you are certain your workers are in fact independent contractors, you can file IRS Form SS-8 (“Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding”). Be advised, though, that if the IRS responds to this form by denying the contractor status, an employer loses certain protections against liability for misclassification.
This is an especially hot topic in the electronic security and systems integration industry. Many companies utilize experienced technicians who do installation and service work on a piecework basis. Both parties may believe that they are operating under an independent contractor arrangement, but the taxing authorities may not agree.
One of the greatest obstacles to treating the workers as independent contractors is licensing. Many states require that alarm companies be licensed and that all personnel be registered with the licensing board of that state. The laws typically dictate that the company has a qualified manager who represents the business. All other personnel are considered employees of the company, and are registered with the board and issued a pocket card.
Many independent contractors do not have their own licensed company and instead carry a pocket card from the company they are working for that states they are an “alarm company employee.” We advise our clients not to treat these people as independent contractors as a true independent contractor would be a qualified manager and would have their own company license.
Although some states allow an independent contractor to perform services as long as they have a pocket card, the IRS and even the state taxing authorities are not bound by this. It’s difficult to imagine trying to defend an employer whose workers were required to be employees in order to legally perform their job duties, but the organization treated them as independent contractors.
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