What are the consequences of treating an employee as an independent contractor?
If you as a California employer classify an employee as an independent contractor and you have no reasonable basis for doing that, you will be held liable for employment taxes for that worker. Internal Revenue Code section 3509 has additional information about the consequences to the California employer as that section discusses several onerous penalties applied against the employer.
If you do not pay those employment taxes, re-read my blog posting on February 16, 2007 regarding the application of the 100% penalty assessment to California employers which is a technique used by the IRS to convert the payroll tax, employee social security tax and Medicare tax from a deductible tax payable by your business to a non-deductible tax that is owed by you personally.
To determine how to treat payments you make for services, knowing about the business relationship that exists between you and the worker performing the services is important. The worker performing the services may be:
An independent contractor
A common-law employee
A statutory employee
A statutory nonemployee
I will focus only on the independent contractor and statutory nonemployees for this California tax blog.
Independence vs. control. Information that provides evidence of the degree of control over and independence of the worker is necessary in determining whether the person providing service is an employee or an independent contractor.
With tax help from a California tax attorney, it is critical that you and your tax attorney correctly determine whether the workers providing services are employees or independent contractors. Generally, if you determine that your workers are your employees, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. If you determine that your workers are independent contractors, you do not generally have to withhold or pay any taxes on payments made to them.
Be careful: If you incorrectly classify a worker as an independent contractor rather than as an employee, you can be held liable for employment taxes for that worker, plus a huge penalty.
Who is an Independent Contractor? A general rule is that you, the California payer, have no right to control or direct the means and methods of accomplishing the result; you do, however, have the right to control or direct only the result of the work done by an independent contractor.
Here’s an example of who is an independent contractor. John Smith, a plumber, submitted a job estimate to an apartment building for plumbing work at $18 per hour for 600 hours. He is to receive $2,160 every 2 weeks over 10 weeks. This is not considered payment by the hour. Even if John works more or less than 600 hours to complete the work, he will receive $10,800. John also performs additional plumbing work under contracts with other companies that he obtained through internet advertising.
How should I report payments made to independent contractors? To report payments of $600 or more to persons not treated as employees for services performed in your trade or business, you may be required to file information returns to report payments made to independent contractors during the year. Filing Form 1099-MISC, Miscellaneous Income, is a typical form you may be required to file.
Who is an Employee? Typically, anyone who performs services for you is your employee if you can control how it will be done and what will be done.
Here’s an example of who is your employee. Mary Jones is a salesperson employed on a full-time basis Robert Black, a retail carpet and rug dealer. She works 6 days a week, and is on duty in Robert’s showroom on certain assigned days and times. She provides quotes for projects, but her quotes are subject to the sales manager’s approval. Lists of prospects belong to the Robert. She has to develop leads and report sales results to the manager. Since she is very experienced, she requires only minimal help in closing and financing sales and in other parts of her work. She earns a commission and is eligible for prizes and bonuses offered by Robert. Robert also pays the cost of group-term life insurance and health insurance for Mary.
Statutory nonemployees are of two types only one of which is mentioned in this California tax blog: licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if (i) substantially all payments for their services as real estate agents are directly related to sales or other output, rather than to the number of hours worked and (ii) their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
When you are contacted either by the IRS or the California Franchise Tax Board because it wants to re-characterize you workers, you should call your California tax attorney immediately so as to begin discussions with the tax agency which minimizes the impact of treating workers as employees. Call 310.559.5259 or email Mitchell A. Port at help@AskMyAttorney.net to ask for his expertise on your specific situation.