Tax Edge

By Robert Steere, Toolkit Staff Writer

As a small business owner, perhaps you have struggled with the question of how to obtain the services of an individual to perform a function needed in your business. Do you hire a new employee, perhaps on a part-time or temporary basis, that you will have to carefully supervise? Or do you obtain the services of an independent contractor who can take personal responsibility to perform the functions for you?

Whether you hire an employee or obtain the services of an independent contractor can have some pretty substantial tax consequences, among other concerns. It will affect your federal and state reporting requirements, the documentation you must collect and the records you must maintain. It will affect the amount you must withhold from payments to the person, and it will have an impact on the amount of tax and other costs your business must bear.

Generally, you must withhold and pay income taxes, Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.

It is important to make a wise decision, and to properly report the working relationship between your business and any individual performing services for it. Making a mistake in how you characterize the working relationship can cause grief to everyone involved, and can result in additional taxes and penalties. In an effort to help you understand the legal distinctions between an employee and an independent contractor, the Internal Revenue Service has just issued Summertime Tax Tip 2009-20. Here is the IRS's list of the top 10 things every business owner should know about hiring people as independent contractors versus hiring them as employees.

1. To determine whether a person is an employee or an independent contractor, the IRS analyzes three characteristics of the relationship between a business and the person providing services to it: (1) behavioral control, (2) financial control, and (3) type of relationship.
2. To analyze behavioral control, the IRS reviews the facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
3. To analyze financial control, the IRS considers the facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job.
4. To analyze the type of relationship, the IRS considers how the business owner and the worker perceive their relationship.
5. If the business owner has the right to control or direct not only what is to be done, but also how it is to be done, then the worker is most likely an employee.
6. If the business owner can direct or control only the result of the work done - and not the means and methods of accomplishing the result - then the worker is probably an independent contractor.
7. Employers who misclassify workers as independent contractors instead of employees can end up with substantial tax bills. Furthermore, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.
8. Workers can avoid higher tax bills and lost benefits if they know their proper status.
9. Employers and workers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing with the IRS a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
10. You can learn more about the determination of a worker's status as an Independent Contractor or Employee at the IRS web site discussion page. Additional resources include IRS Publication 15-A, Employer's Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS web site or by calling the IRS at 800-829-3676 (800-TAX-FORM).

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