The Fourth of July and other holidays are a great time to get together with family and friends, enjoy fun, laughter and good company, and chat… about taxes?
Every so often when someone finds out what I do for a living, I’ll hear “Hey, I have a question.” Usually, my answer to a question is “it depends” – because there are far more “Green Lights” in our tax laws than “Red Lights.” Red lights are where we must stop and pay tax. Green lights are where we get to go through the intersection without paying tax. And which Green Lights we use is based on your situation and goals.
Of course, on Independence Day, we celebrate our country’s declaration of independence – primarily because of the issue of taxation without representation (though it’s been said taxation WITH representation hasn’t been so great either 😉 ). But on a tax-related holiday, today’s question came from two different people and is a relatively well-documented Red Light that often puts business owners AND workers between a rock and a hard place.
In this case, the question was what determines whether a worker for a company is an EMPLOYEE or a CONTRACTOR. Many years ago, IRS used a 20-Factor test for Independent Contractors. The criteria are now more broad and nebulous, but the impact from losing a worker classification audit is still severe.
IRS conducts worker classification audits on a regular basis. The problem with worker misclassification is significant and erring on the wrong side can result in back taxes, penalties, and interest on unpaid taxes for the business owner. Additionally, because IRS and States share information with each other, a successful misclassification case will result in the other agency looking to the employer for their share of the employment tax pie.
For the worker, if they are misclassified as contractors, they will end up paying not only income tax on their earnings, but self-employment tax of 15.3%, which amounts to both halves of Social Security and Medicare taxes that are paid on EMPLOYEE wages (one half is withheld by from the employee’s pay, the other half is paid by the employer.) Contractors, because they are not employees and the company is not paying Federal and State unemployment taxes on their earnings, are not eligible for unemployment compensation if they are terminated or laid off.
So here’s the motivation from both sides:
Business owner pays a worker as a contractor:
- The company DOES NOT pay any payroll taxes on those wages/earnings, saving 6.2% Social Security, 1.45% Medicare, and anywhere from 1% to 8% in combined federal and state unemployment taxes depending on location and what is known as “experience rating.” So for a part-timer earning $10,000 per year, the company has saved at least $765 in tax expense, and does not have to provide any benefits if they offer those to other employees.
- The company does not see their experience rating for how much they pay in unemployment insurance increase, because contactors cannot file a claim for unemployment benefits when they are terminated or laid off (there are a few exceptions to this.)
The primary downside for the worker is even though they may qualify for the standard deduction for income taxes and not owe any federal income tax, they WILL be required to file a tax return and pay 15.3% self-employment tax on their net income: the filing threshold for self-employed contractors is only $400 in net income. That is significantly below the filing requirement of $12,950 for single taxpayers for 2022.
However, if the worker has out of pocket expenses such as auto mileage, tools, etc. that are not reimbursed by the employer, as a self-employed contractor these potentially become deductible expenses to reduce their self-employment income.
Worker is paid as a W-2 employee:
- The worker only pays one half the Social Security and Medicare tax on their earnings. The other half is paid by the employer.
- The worker may be eligible for company benefits if they are qualified.
- The worker may be eligible for unemployment compensation if they are terminated or laid off.
The downside for the employer again is the increased expense of the employer side of payroll taxes, benefit expenses, and unemployment taxes.
Let us know if you need help.
Whether you are a business owner who has questions about worker classification or may have misclassified workers as independent contractors and want to know you options, or you are a worker who has been paid as a contractor and believe you should have been paid as an employee, contact our office for help and resources.