Independent Contractor Rules
U.S. Employee (W-2) OR Contractor (1099-MISC) Guidelines

by L. Kenway BComm CPB

What You'll Find In This Chat ...

Let's chat about good bookkeeping practices.
  • Form 1099-Misc
  • Form W-9
  • Form 1096
  • Form 4699
  • US Citizen Employed By Canadian Company
  • Written Agreement Checklist
  • Voluntary Classification Settlement Program
IRS Independent Contractor Rules

Independent contractor rules assist the IRS in determining whether you have correctly classified your employees and contractors.

Employee payroll tax rates and benefits are more costly to the employer. It can be advantageous to hire an independent contractor (IC) instead of an employee ... that's why it is a frequently audited area.

Make sure you verify that your independent contractors actually meet the criteria ... and are not really employees.

Consider viewing the 2015 IRS webcast on Payments to Independent Contractors or download the transcript ... choose your preference.


INDEX for Federal Payroll Taxes Series
Click on any image below to go to the article.

Part 1

Social Security Rates

Employee Payroll Taxes

✔ FICA & FUTA Rates

✔ Business Travel Allowances

✔ and more

Part 2

Payroll Tax Deposits

✔ Payroll Tax Deposits

✔ Forms 940 & 941

✔ Correcting Form 941

✔ Notice 4520

✔ FUTA Credit Reductions

Part 3

W-2 W-3 W-4 Forms

✔ Employment Forms

✔ W2, W3, W4

✔ Form 1-9

✔ New Hire Paperwork

Part 4

Independent contractor rules

✔ Independent Contractor Rules

✔ Forms W9, 1096, 945, 1099-MISC

✔ VCSP



GOOD TO KNOW

How IRS Audits For The Independent Contractor Rules

Click here to find information on how the IRS is using the Form 1099-K and how it affects processing of your 1099MISC.

At the American Payroll Association's (APA) 29th Annual Congress, Steve Hodgson, CPP explained that one way the IRS audit independent contractors
is through the 1099 Matching Program.

IRS auditors look at individuals who have only filed one Form 1099-MISC indicating they may be an employee and not a contractor; or individuals who receive a Form 1099-MISC from the same business in more than one year.



                               good bookkeeping practice
THE BOOKKEEPER'S|TIP    

Form W-9 and Form 4699

UHY Advisors recommend that you should receive and have on file a Form W-9 Request for Taxpayer Identification Number and Certification from each independent contractor; complete with address and TIN ... BEFORE they do any work for you.

Consider including in the written agreement an outline of their federal tax obligations.

AIPB's December 12, 2011 free eNewsletter advised that in addition to sending independent contractors a 1099-MISC, you should also have each independent contractor sign Form 4699 - Statement of Payments Received ... especially if you have few or no employees.



What Are The Independent Contractor Rules?

The IRS have an excellent 2 page pamphlet (publication 1779) that discusses the subject. It is concise, easy to read. It is titled Independent Contractor or Employee and can be found at www.irs.gov/pub/irs-pdf/p1779.pdf .

This pamphlet looks at the three categories the courts have considered when determining whether a person is an employee or an independent contractor:

  1. behavioral control-right to direct or control how the work is done such as who gives instructions and provides necessary training;
  2. financial control - right to direct or control the business arrangement including how expenses are handled; and
  3. relationship of the parties - how the parties perceive their relationship including evidence of a written contract and/or employee benefits.

The Montana Arts Council website (art.mt.gov) has a PDF you can download called IRS 20 Point Checklist for Independent Contractors that lays out the independent contractor rules. The 20 items checklist identified below all fit into one of the IRS's three categories of independent contractor rules shown above.

I've listed the independent contractor's checklist discussed in the article and added which IRS category I think they fall under:

  1. Profit or loss - financial control 
  2. Investment - financial control 
  3. Works for more than one person at a time - behavioral control 
  4. Services available to general public - relationship of the parties

  5. Instructions - behavioral control 
  6. Training - behavioral control 
  7. Integration - behavioral control 
  8. Services rendered personally - relationship of the parties 
  9. Hiring assistants - behavioral control
  10. Continuing relationship - relationship of the parties
  11. Set hours of work - behavioral control
  12. Full time required - relationship of the parties
  13. Work done on premises - behavioral control
  14. Order or sequence set - behavioral control
  15. Reports - relationship of the parties
  16. Payment method - financial control
  17. Expense reimbursement - financial control
  18. Tools and materials - behavioral control
  19. Right to fire - relationship of the parties
  20. Right to quit - relationship of the parties

Answer these questions to help determine if you are an independent contractor or an employee:

  • Do you receive a 1099-MISC ... or a W-2?
  • Are you responsible for paying your own taxes ... or are they deducted from for you from your remuneration?
  • Do you file a Schedule-C to report your expenses ... or are they reimbursed on Schedule-A?

Independent contractors receive a 1099-MISC, pay their own taxes and may deduct expenses on Schedule-C when filing their income tax return.

Yearend Reminder
Tax Compliance

Independent Contractor Rules

Your 2015 1099-MISC forms should be presented to service contractors by February 1, 2016. The contractor receives Copy B.

You may file the forms using a truncated taxpayer identification numbers (TTIN) ... the first five digits are replaced with an "x" or "*" ... to prevent identity theft.

The IRS receives Form 1096 Annual Summary and Transmittal of U.S. Information Returns AND Copy A by February 28 ... March 31 if filed electronically.

To send the 1099s by email requires the explicit permission of the contractor.

Form 945 Withheld FIT on Form 1099 is also due February 1, 2016.

As Robert Wood, tax lawyer and Forbes columnist likes to say, "It's better to give than receive." :)

Source: The Bookkeeper's Notes Newsletter

According to Jean Murray in What Factors Does the IRS Look at in Determining Independent Contractor Status?, the IRS does not look at any one factor but at the "whole" picture the answers to the questions create. Jean also mentions that IRS starts with the presumption that the worker is an employee.

AIPB's free newsletter dated October 1, 2012 reviewed an IRS court case they won and the individuals were classified as employees rather than independent contractors. The court stated the facts and circumstances they used to make their decision were:

  1. the degree of control exercised by the principal;
  2. which party invests in the work facilities used by the worker;
  3. opportunity of the individual for profit or loss;
  4. whether the principal can discharge the individual;
  5. whether the work is part of the principal’s regular business;
  6. the permanency of the relationship; and
  7. the relationship the parties believed they were creating.


As a general rule, the business owner does NOT withhold taxes when paying an independent contractor for services ... but you MUST report amounts paid to the IRS in Box 7 on Form 1099-MISC. The independent contractor receives a copy of the 1099 and is responsible for calculating and remitting the related self-employment taxes.


Penalties Are Stiff For Not Following
The Independent Contractor Rules

Who Should Receive a 1099-MISC?

Tax Compliance
Independent Contractor Rules

3 General Rules

One - Only payment for services delivered (not merchandise goods) to your business are reported. This means personal payments to you are excluded. It also means wages to employees are not reported here.

Two - Payments that total $600 or more for the reporting year AND were paid to an individual (meaning sole proprietors, independent contractors, or self-employed) are reportable on the Form 1099.

Three - Payments were made by cash or cheque are reportable on the Form 1099. Payments made through a third party provider (i.e. credit card or PayPal payments) will be captured on a 1099-K.


See the compliance reminder above for current due dates.

Real estate agents are not considered individuals for these purposes so do not report rent paid to real estate agents.

Payments to corporations are not reported unless it pertains to medical and health care payments, attorney's fees, or cash paid fish purchases ... yeah you read that right ... cash paid fish purchases ... it's one of those quirks!

An article by Nina Kaufman, Esq. from Ask the Business Lawyer.com on How Independent Contractor Agreements Protect your Pocketbook explains one of the ways government raises revenue is by "more closely enforcing their laws, and levying penalties against those who violate them."

If you intentionally misclassify a worker as an independent contractor, the IRS can reclassify the worker as an employee.

When this happens, the employer (that would be YOU) would be responsible to pay ALL related payroll taxes and withholdings including the employee's portion ... plus late payment penalties and interest. If this happens to you, make sure you get legal adivice on safe haven provisions as it pertains to your situation.

The IRS can also assess failing to pay employment taxes and failing to file required tax form penalties. State penalties also apply.

The employee payroll tax penalties are reduced if the worker was unintentionally misclassified. NACB Payroll Tax Update reports:

"The IRS penalty for unintentionally failing to withhold federal income tax is 1.5% of the wages paid. This assessment is doubled to 3% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS. The IRS penalty for unintentionally not withholding the employee's share of Social Security and Medicare taxes is 20% of the employee's share of the tax. The penalty is doubled to 40% if the employer failed to file an information return for the worker with the IRS."

Nina explains that a written agreement can be a valuable weapon if/when one of these three scenarios puts YOU as a small business owner on the IRS's radar.

  1. "The service provider freelances for you while working full time for another company. When laid off, the service provider lists you as someone she’s done work for in the previous year.
  2. You provide an independent contractor with a long-term assignment. Because of the economy and your budget constraints, you need to let the person go. Disgruntled, he files a claim for unemployment benefits.
  3. A freelancer gets injured while performing services on your job site. Somehow, the claim gets filed through Workers’ Compensation."



THE BOOKKEEPER'S NOTES ON

IRS Form 1099-MISC

When completing the IRS Form 1099-MISC, always use the individual's legal name for a sole proprietorship or independent contractor.

However, if the business operates under a DBA (doing business as), use the DBA name on the Form 1099.

When preparing the Form 1099 for a business or partnership, use the entity's name.

Even if you paid the Independent Contractor by credit card or PayPal, you may still need to send a 1099-MISC for any amount paid by cash/cheque if the criteria (see side bar above) is met. Does this mean that some payments will not be captured on either the 1099-MISC or the 1099-K? Yes but not your problem. Why? You don't know if the IC will receive a 1099-K. You don't know if the IC had over $20,000 in sales and over 200 transactions. 


If you hire ICs, you want to be up on your independent contractor rules. A good place to start is the IRS webcast on 1099 MISC Filing requirements at:

www.irsvideos.gov/sbv_1099webinar/index.htm

While it is directed to governmental agencies, you may find some useful information.

The transcript says it will cover "your responsibilities for filing Form 1099‑MISC and the corresponding Form W‑9. We will be discussing reporting of rents, nonemployee compensation, royalties, other income and gross proceeds to attorneys." Backup Withholding was also discussed including how to deposit it.

At the above link, you will find a transcript of the webcast (great if you prefer to read  ... which I do ... much faster than watching a webcast), a copy of the slides used in the presentation and the handouts.

The handouts are good. They summarize the webinar with all the important points ... just as if you took notes at a lecture.

Source: IRS & AIPB & Tax Receipts.com



If you decide you need more information about the independent contractor rules, an additional reference to consult is the IRS Publication 15-A Employer's Supplemental Tax Guide.

If after reading the IRS information you still aren't sure how to classify your worker ... employee payroll tax help is available. Ask for an IRS ruling by filing Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Another good resource you might want to tap into for independent contractor rules is SBA.GOV (www.sba.gov)> establishing a business> hiring> independent contractors vs. employees.

They published a great article on November 7, 2011 titled, "How to Use Subcontractors to Save Money and Increase Business Agility" by Caron Beesley. You can locate it at SBA.GOV> Community Home> Community blogs> Small Business Cents. It discusses the pros and cons of working with subcontractors.

SBA.GOV (formerly Business.GOV) is the official business link to the U.S. Government.


THE BOOKKEEPER'S NOTES ON

US Citizen Contracted By Canadian Company

If you are a Canadian company and hire a US citizen under independent contractor rules, you will need to send the IRS Form 1099-MISC.

To do this, you will need the US citizen's social security number.

Don't forget to give the US citizen a copy of the IRS Form 1099-MISC for their records to use for their income tax preparation.

You can find a copy of the IRS Form 1099-MISC at www.irs.gov/pub/irs-pdf/f1099msc.pdf ... BUT you can't file the online form as it is not scannable.

You order the form from IRS free of charge. If you are located in the U.S., contact the IRS toll free at 1-800-TAX-FORM.

However, if you are in Canada, alas the toll free number does not work. You will have to telephone or FAX the Philadelphia Service Center office for assistance at:

Tel: 215-516-2000 (not toll-free) or Fax: 215-516-2555





LET'S CHAT ABOUT ...

Written Agreement Checklist

Robert Woods, tax lawyer, author and blogger wrote, in a checklist about the independent contractor (IC) rules, about what to include in a written agreement.

The written agreement should cover who has "the right to control the manner in which services are performed. Consider obligating the employer to pay for a finished product."

All you efficient bookkeepers out there, take note. Mr. Woods says the contract should NOT be a template. Use the checklist to customize each written agreement and state the facts of each agreement by clearly discussing the following independent contractor rules.

  1. Name and Titles - clearly state it is an independent contracting agreement, name the person performing the service, avoid employee terms
  2. Instructions and Training - the IC, not the company, determines the when, where and how and provides their own training. The company can detail the final product specifications.
  3. Right to Delegate - IC can assign, manage and monitor their own employees' work on the contract; ICs can hire assistants, etc.
  4. Duration and Hours - a shorter contract is better than a longer contract; scheduling of work is IC's responsibility.
  5. Full Time and Exclusivity - rather than state hours required, state a final product deadline. The IC should have more than one client.
  6. Work Site and Reports - IC determines where work is performed; reporting requirements (written or oral) should not be mentioned/required in the agreement. A final report upon completion of final product is okay.
  7. Payments and Expenses - Generally avoid reimbursements; travel reimbursement is acceptable if contract contains the provisions; payment is made on presentation of invoice(s) which is preferably not billed by the hour, week or month but on progress of contract completion.
  8. Equipment and Investment - state that they are supplied by IC
  9. Profit or Loss and the Public - IC responsible for economic risks; IC should not be backstopped by company.
  10. Discharge and Termination - IC includes termination provisions; there should be a liability clause to the company if they terminate the agreement.

To read Mr. Woods entire article, which I recommend, Bing/Google "Ten Tips for Drafting Independent Contractor Agreements". You are looking for the Daily Tax Report Vol. 10, No. 125 July 1, 2010.

You may also want to read Robert Wood's article in Daily Tax Report Vol. 9, No. 195 from October 13, 2009 titled "Ten Things GAO Has to Say About Employee/Contractor Misclassification".



Independent Contractor Rules Update
IRS Voluntary Classification Settlement Program

On September 5, 2011, the IRS introduced a new program that allows tax relief to eligible taxpayers for reclassifying independent contractors as employees. The program is called Voluntary Classification Settlement Program (VCSP).

The program was modified in 2012.

If you have consistently (for the past 3 years) followed the independent contractor rules by treating your workers as independent contractors AND filed all the associated Form 1099-MISC paperwork AND are not currently under audit BUT want to prospectively treat them as employees THEN file Form 8952 60 days before you begin the reclassification.

It does require you enter into an agreement with the IRS agreeing to pay 10% of the amount of employment taxes calculated with NO penalties and interest AND you will NOT be subject to an employment tax audit for the prior years.

Announcement 2011-64 at www.irs.gov/pub/irs-drop/a-11-64.pdf was superceded by Announcement 2012-45 at www.irs.gov/pub/irs-drop/a-12-45.pdf. Visit the IRS website for more information.


I'll close this chat on independent contractor rules by quoting Nina's article mentioned above.

"If your company uses independent contractors to staff its work force, be very careful that you do this properly. You want to be sure to use people who can properly be classified as independent contractors and are not just part-time employees in disguise."



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