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March 31, 2009

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Whenever you hire someone to help you in your business or just to help around the house, one of the first things you have to decide is whether the worker qualifies as an employee or independent contractor for IRS purposes.

Whenever you hire someone to help you in your business or just to help around the house, one of the first things you have to decide is whether the worker qualifies as an employee or as an independent contractor for IRS purposes. If the worker is an employee, you generally must pay half his or her Social Security and Medicare taxes out of your own pocket and withhold the remainder from the worker's paychecks and pay it over to the IRS. You must also withhold and pay over the worker's income taxes. In contrast, if the worker is an independent contractor you don't have to withhold or pay anything.

Clearly, then, classifying a worker as an independent contractor for IRS purposes can save you both money and bookkeeping headaches. The problem is, how do you know whether a worker qualifies as an independent contractor or should be classified as an employee instead? This is not an idle question. If you're audited by the IRS and it determines you've mis classified employees as ICs, it will impose substantial assessments, penalties and fines.

People who hire independent contractors have been complaining for years that it was often impossible to know for sure whether the IRS would view the workers as employees or independent contractors. This is because the IRS used a complex and unwieldy 20 factor test to determine how to classify workers. Even the IRS found it difficult to apply this test consistently. People performing the exact same services have been found to be employees in some IRS districts and ICs in others. In one case, for example, a Methodist minister was found the be an employee of his church; a Pentecostal pastor was found to be an independent contractor in another case the same year.

Fortunately, 1997 ushered in a new era for firms that hire ICs. A law called the IRS Safe Harbor, also known as Section 530, has been significantly expanded and liberalized, both by Congress and the IRS itself. As a result, many hiring firms can avoid problems with IRS audits without having to satisfy the complex 20 factor test.

The IRS Safe Harbor does not make anyone an IC. Rather, if you meet the Safe Harbor requirements, the IRS won't even bother to determine whether workers you've classified as ICs really are ICs under the 20 Factor Test for employment and income tax purposes. You may continue treating the workers involved as ICs for these purposes and the IRS will not question their status. This means you need not pay the employer's share of the workers' Social Security and Medicare taxes or withhold income or Social Security taxes from their pay. However, the workers could still be considered employees for other purposes such as pension plan rules and state unemployment compensation taxes.

~To qualify for Safe Harbor protection, you must satisfy just three requirements:
  • you must have filed all required 1099-MISC forms reporting to the IRS your payments to the workers in question
  • you consistently treated the workers involved and others doing substantially similar work as ICs, and
  • you had a reasonable basis--that is, a good reason--for treating the workers as ICs.
The reasonable basis requirement is usually the most difficult to satisfy. There are many ways to do so--for example by:
  • showing that treating such workers as ICs is a common practice in your industry
  • obtaining a letter from an attorney or accountant stating that the workers qualify as ICs
  • showing that you were previously audited by the IRS and the status of similar workers was not questioned, and
  • obtaining a copy of a court decision or IRS ruling that similar workers qualified as ICs.
Because the Safe Harbor is simpler than the common law test and should yield far more certain and consistent results, hiring firms that qualify for Safe Harbor protection can classify workers as ICs with far more confidence than in the past.

However, not all firms are able to use the Safe Harbor and its protection can easily be lost. The time to start thinking about the IRS Safe Harbor is when you first hire an IC. Don't wait until an audit begins, by then you may have already lost your Safe Harbor protection. If you've already hired ICs, don't despair. You may still qualify for the Safe Harbor - if not for all, then at least for some of your ICs.

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Filed Under: Workplace Issues
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