Small Business Owners: Are Your Workers Employees or Contract Labor?

November 1, 2011 by
Filed under: Small Business 
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The biggest issue you’re going to face as a small business owner this year is whether or not the people you hire to work for you are employees or contract labor. This is such a hot topic with the IRS right now that they’re currently running a Voluntary Compliance Program—giving businesses a chance to “change their minds” about how their workers are classified. It’s called the Voluntary Classification Settlement Program (VCSP).

Basically, with the VCSP, if a business has been calling workers contract labor when they really should have been labeled as employees, you get a chance to go in and change your employee’s status before the IRS nails you instead.

So how do you know if you’ve got an employee versus a contract labor situation? That’s a really tough call sometimes and the law isn’t very clear. It’s all based on what’s known as “common law,” which means the issues have been settled in court cases instead of legislation spelling out the rules for us. The basic common law rule that defines an employee is that the service recipient (in English that’s the boss) has the right to direct and control how the service is performed.

Let me use an example: let’s say you hire me to do your taxes for you (Good idea, actually). In this case I would be contract labor to you. You will tell me what you need done, and supply me with the information to do it, but I’m going to use my software programs, my office, my stuff in general. I’m going to do it my own way, when I want to, and wear my pajamas at work if I want. That’s contract labor. (By the way, I never wear pajamas to work but I sometimes wear a St. Louis Cardinals jersey.)

But I used to be an employee at a large tax company. While I was working there, I used my boss’s software, I had certain hours that I had to be in the office, I arranged the paperwork for the files exactly as I was instructed (with the staple in the top left hand corner horizontal to the box in the big numbers in it) etc., etc.. My Cardinals jersey would have been a dress code violation and I would have been sent home. I could have even done your taxes while I was working for that company, but you weren’t really hiring me, you were hiring that company that I worked for.

You see how those two examples are different? Even though there isn’t an absolute, defining definition of what makes a person an employee, it’s sort of like Justice Potter Stewart’s famous quote about obscenity, “…I know it when I see it.”

I work with a lot of clients who are classified as 1099 contract laborers but should be labeled as employees. Most of them will never file a complaint with the IRS for fear of losing what jobs they do have, so employers have been pretty safe up until now. But the IRS isn’t stupid (Yes, I put that in writing). If I can look at a 1099 MISC and figure out that the person is really an employee instead of contract labor, the IRS is able to set up a computer screen and they’re going to be able to target suspicious 1099s as well. Did I mention, they’ve been updating their equipment? Faster, stronger, better—it’s like the $6 million man but more expensive.

So how do the people you hire stack up? If you’re paying people as employees, and properly paying your withholding taxes, then you’ve got nothing to worry about. If you’ve got employees but you’re paying them as contract labor it’s time to take a good hard look and decide if you’re doing the right thing. Using the common law test of “direct and control” are these people really contract labor or should you reclassify them as employees? If they should be called employees, you’ll want to find out more about the Voluntary Classification Settlement Program.

The VCSP has a whole list of requirements and there will be costs attached. Although that’s a little scary, it’s much better than the costs associated with an audit over your worker classification. To find more information about the VCSP, here’s a link to the IRS website: http://www.irs.gov/businesses/small/article/0,,id=246013,00.html

It’s perfectly legal to hire contract labor—it’s a very normal, regular part of business and many businesses couldn’t function without it. When you cross that line, when you’re really hiring employees but you’re just calling them contract labor to avoid paying payroll taxes– that will get you into trouble.

Comments

4 Comments on Small Business Owners: Are Your Workers Employees or Contract Labor?

  1. Malissa on Sat, 28th Jul 2012 3:21 pm
  2. Ok.i work at a salon off of commission only an the owner doesnt take any taxes out of my checks.so and I use my own equepment to cut hair.i found out that puts me as contract laborer.does the owner have the rite to tell me when I can leave an come to work,clean the shop an do the book work?when im a hair stylist?or do I have the right to leave an come to work freely an nt to have to do the books?

  3. Admin Roberg on Sat, 28th Jul 2012 4:05 pm
  4. Hi Malissa,
    Generally, salon stylists are contract labor. At least all the stylists that I’ve done taxes for have been contract labor–that said–I’m more likely to prepare tax returns for folks with 1099s than with w2s so I’m not the final say on that.
    Anyway, your questions is about your hours and duties–and I can’t answer that. You see–that’s all negotiated between you and the person who hired you. And being contract labor–you’re walking a fine line. For example–as contract labor you are technically free to come and go–but, likewise–your employer is free to say “we no longer have a working agreement”.
    It seems reasonable that you would have to clean up the shop if you’re working there–you cut hair, it makes a mess, etc. And there’s probably a reasonable amount of book work that you must do as well. Doing her books? That sounds a bit like an employee, but I’m not there so I can’t tell.
    It seems to me that you need to sit down with your employer and discuss what your role in the shop really is and lay out some ground rules. A question for you is–how good are you at what you do? The reason I ask is–you you’re that good at hair–then you’re coming from a position of power, your clients will follow you if you leave. If you’re just starting out–you have no client base and no power. And it might be a good time to “suck it up” and learn the ropes a bit. She might be doing you a favor having you work on the books. I’m not there so I really can’t judge the situation. But as far as the IRS rules about employees is concerned–generally they look at hair stylists as contract labor.

  5. Tracy Leger on Wed, 16th Jan 2013 10:08 am
  6. I joined a salon that was opening from the ground up and we were hired as employees, signed contracts as employees stating we could not conduct business outside of the salon, are paid commission and automatically have a product fee deducted from our checks which was never discussed. We filled out W-2’s and I-9’s, not 1099’s. Now we’ve been informed that we are being switched to contract labor to avoid the employer having to pay for workmans comp insurance. Are we now obligated to carry insurance on ourselves as stylists, and are we classified as employees or contract labor since the employer provides all the supplies. I’ve been both. The way they have set it up now requires us to claim our own income and pay taxes on it but they get to claim the deductions for supply cost and overhead leaving us with nothing to offset our income. Where is the line on this? Is this legal? Or are they required to switch to charging us booth rent making us responsible for our own supplies, hours and prices so that we are truly contract labor? Is it even legal to make the switch without renegotiating the original agreement with the employees?

  7. Admin Roberg on Wed, 16th Jan 2013 9:19 pm
  8. Hi Tracey,
    It’s a tough call. Salon workers are often independent contractors, so that’s not unusual. But, still, you did start as an employee. I don’t know.
    This link is to the Missouri Department of Labor’s booklet about contract laborers: http://www.labor.mo.gov/DES/Forms/M-INF-310-AI.pdf

    There’s a whole bunch of criteria in there to determine if someone is an employee or not. You don’t have to meet all of them, but I think this booklet makes for a really good guideline. I was talking to a woman who works for the Missouri Department of Labor and one thing that she told me was that if Missouri determines that someone is an employee, the IRS has always agreed–so I think the Missouri guidelines are pretty legit. You might want to contact the department of labor in your own state so see how they feel about it.

    Now, about the deductions–remember, anything that you do have to pay for you write off as a deduction against your salon income. So if your employer is withholding income from you for supplies, remember that you’ll get a 1099 that includes the whole amount and you have to deduct the supplies on your personal return. For example. Let’s say you should have been paid $100 but he withholds $10 for shampoo–he’ll issue you a 1099misc for the $100 and you need to report the $10 for the shampoo that he withheld from your pay. (I just amended a return like that, don’t pay more tax that you really owe.)

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