| Before we begin, are YOU an employee? |
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Sole Proprietors:Since you own a sole proprietorship,
you are not an employee. You are the owner. Any money you take from
the company is a draw on your company's after-tax profit. It is not salary.
Do not pay regular employee-employer taxes on yourself. Instead, you must
pay social security self-employment tax on the first $106,800 in profits and
Medicare taxes on all your profits. These are explained with Schedule SE
Self-Employment Tax.
Partnerships: Partners are not employees; they are owners. Any money taken from
the company is a draw on their share of the company's after-tax profit. It is not salary.
Do not pay regular employee-employer taxes on partners. Instead, partners must
pay social security self-employment tax on the first $106,800 and
Medicare taxes on all the profits that they receive. These are explained with
Schedule SE
Self-Employment TaxLLCs LLC members are owners, not employees. Any money they take from the LLC is a draw on their "capital account", it is not salary. Do not pay
regular employee-employer taxes on payments made to members.
Members are responsible for paying their own taxes on their portion of the LLC's
net income, regardless of whether they received the net income in cash. Each member must pay
social security self-employment tax and income tax (see
Schedule SE and 1040ES).
Non-member managers are automatically employees.
Corporations: If your corporation has anyone actively involved in its operation, it is an employer.
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| Are your other workers employees? |
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IRS rules determine this, not an agreement between you and the worker.
The IRS presumes that, except for statutory non-employees described below, all workers
are employees unless the hiring firm can legally prove otherwise.
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| Corporations: Are shareholders, officers or directors
employees? |
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If you work for a corporation and receive compensation for your work, you
are an employee - even if you are the only shareholder. You should pay regular employment
taxes on these wages.
Corporate directors are generally paid as independent contractors. However, this only applies
to payments for
services they render as a corporate director. Any income that they receive for general services
must be taxed as a regular employee.
Corporate officers' income must be taxed as regular employees.
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Corporations: Can you pay dividends instead of salary? |
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Some sole shareholders try to avoid employment taxes by paying themselves a very small salary and "distributing" the remainder of the corporation's profits as dividends. Before
you do this, remember that you may be audited and will have to show that:
- Your wages were typical for your job and industry;
- Your dividend income was not a result of your direct labor.
There is an exception: Income from royalties are not considered wages for employment tax purposes,
but are earnings based on the corporation's assets.
| | The IRS has two classifications |
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The IRS has two classifications for workers: non-employees and employees.
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| Non-employees
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Non-employees include independent contractors and statutory non-employees.
Independent contractors must:
- Offer their services to the general public
- Supply their own tools and a place to work AND
- Control the methods used to accomplish the work; hiring firms
should only be concerned with the end result.
Statutory non-employee Specific laws designate that the following workers are automatically non-employees:
- Direct sellers who sell products door-to-door to the final user
- Licensed real estate agents.
If you use non-employees in your business, you do not have to withhold or pay any employer taxes.
Send your non-employees annual 1099Misc forms. |
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| Employees |
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Any non-owner who was not described under non-employees above is
an employee. There are two categories of employees: statutory employees
(where a specific law automatically makes them an employee) and common law employees.
Statutory employees
- Food (except milk) and laundry drivers;
- Full-time traveling salespeople who sell goods to people who will re-sell the item;
- Full-time life insurance agents working mainly for one firm
- At-home workers who are supplied with the materials or goods and are given specifications of
the work to be done.
California has additional statutory employees:
- Workers hired by licensed contractors. This includes construction workers, clean-up workers at construction sites, painters, home insulators, linoleum installers, interior decorators, HVAC servicers and scaffolders;
- Artists and authors under collective bargaining or commissioned work.
Common law employees
- Everyone else not described in non-employees or statutory employees above (including family members)
If you have employees: you will have to file employer forms and withhold and pay employee-employer taxes.
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| Warning if you want to use independent contractors |
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If you plan to hire independent contractors instead of employees,
it is NOT enough to rely on the three characteristics listed above. There are additional
rules and specific do's and don'ts that you must follow or you will be vulnerable to
substantial government fines.
The IRS and other agencies conduct routine audits and fine companies that ignore these rules.
Many (if not most) companies lose the audits. The fines and back taxes can easily be
$25,000 for one misclassified worker.
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| Independent contractors...the bottom line |
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In a true independent contractor relationship,
the hiring firm has no right to control the worker or the work.
The hiring firm can only control (specify) the results of the work - not how
the work is accomplished. If you hire independent contractors, you must be
willing to give up control over their actions. That means:
- No set work hours
- No rules
- No supervision
- No reports
- No supervising their assistants
- No ability to fire at will
- No changing their work or schedule without their permission
- No deadlines, unless agreed upon in a contract
- No training
- No ongoing instructions
- Treating your independent contractors as if they each own a business with 20 employees.
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| Myths that cause firms to lose audits |
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Independent contractor status is NOT determined by whether the worker:
- Asked to be treated as an independent contractor
- Has a written contract
- Works for you sporadically, inconsistently or on call
- Is paid commission only
- Works without supervision
- Works for more than one company.
The only test to a true independent contractor relationship is whether the hiring
firm had the right to control the worker or the process of his work.
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| Who has right to control? |
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It is difficult to define what "right to control" is.
The IRS has developed twenty factors which point to a right of control. Many of these
factors are listed above. Independent contractors do not have to meet all twenty
factors, but the hiring firm must clearly show that the factors that were not
met were not important for that job or industry.
In addition to complying with the twenty factors, hiring firms cannot treat their
independent contractors like employees. Many firms have lost audits because they
ignored small details such as:
- Had their contractors complete employment applications or time sheets
- Assigned someone to be their supervisor
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| Contract for Services |
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We have included a standard contract for services to use for independent contractors.
You do not have to have a contract to satisfy IRS rules, however, it helps both you and the contractor
stay within the normal bounds of an independent contractor relationship. Please note, that signing
the contract without following it, will not help.
Click here for the contract for service agreement.
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| IRS forms |
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There are two optional forms you can use for an official ruling on whether a worker is an independent contractor.
SS-8 Determination of Workers Status is used for an official IRS ruling on whether a worker is an employee
or a contractor. Please note that even if you get a positive ruling, if later, you treat the worker as an employee,
the ruling will be invalid. California has a similar process, using form DE-1870.
To obtain the form, visit http://www.edd.ca.gov/Payroll_Taxes/Forms_and_Publications.htm. W-9 Request for Taxpayer ID Number is used
by some businesses for the contractor to certify that they are providing you their correct taxpayer ID number.
Since this form is never sent to the IRS and does not help you in an audit, it is of questionable help.
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| California Report of Independent Contractor(s) DE-542 |
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California requires that any business which is required to file a
1099-M for an independent contractor
must also report that independent contractor to the state Employment Development Department. The purpose
of this is to locate parents who should be, but are not now, paying child support. See
Report of Independent Contractor(s) DE-542 for more information.
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| Questions? | |
The Employment Development Department publishes a brochure called "Independent Contractor Misconceptions" which is available at
http://www.edd.ca.gov/pdf_pub_ctr/de573m.pdf.
You can also call the IRS information hotline (800) 829-4933. For forms, call
(800) 829-3676 or obtain them online at http://www.irs.gov/formspubs/index.html.
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