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Independant Contractors vs Employees

TAX AND OTHER BENEFITS OF INDEPENDENT CONTRACTOR CLASSIFICATION
Businesses that hire employees are responsible for payroll taxes, employee benefits, and the related administration and compliance tasks arising when wages are paid to employees. Businesses generally do not have these responsibilities for independent contractors—they need only file a Form 1099-MISC for the payments they make to the contractor.

Example: Key Differences Between Employees and Independent Contractors
Hi-Tech Corporation is restructuring its product lines and needs production and design engineers to oversee the process. Hi-Tech is investigating whether to hire these individuals as full-time employees or independent contractors. There is enough work for three more-or-less full-time positions for a period of at least three years. Hi-Tech’s bookkeeper studies the employee versus independent contractor issue. He concludes that, by hiring independent contractors, Hi-Tech:

  1. would not have to withhold federal, state, or local income taxes,
  2. <!–[if !supportLists]–> would not have to withhold and pay matching FICA taxes,
  3. <!–[if !supportLists]–> would not have to pay federal and state unemployment or disability taxes,
  4. <!–[if !supportLists]–> would not have to meet federal and state overtime or minimum wage laws,
  5. <!–[if !supportLists]–> may exclude the workers from retirement plans and fringe benefits, and
  6. <!–[if !supportLists]–> may exclude the workers from workers  compensation coverage.

Hi-Tech’s bookkeeper perceives all of these as significant advantages for hiring independent contractors. He concludes that the company would be significantly ahead dollar-wise to contract out for the services. Accordingly, Hi-Tech will recruit potential applicants as contractors, not employees.

For some businesses, the reduction in human resource paperwork and compliance administration is sufficient motivation to have work performed by independent contractors. If potential payroll tax and employee benefit savings are also factored into the equation, it is easy to see why many businesses prefer to hire independent contractors for specialized tasks and jobs of relatively short duration.

Example: Calculating the Tax Savings Associated with Independent Contractor Classification
Assume the same facts above. Before making a recommendation, Hi-Tech’s bookkeeper decides to run the numbers on potential tax savings. He estimates the wages and related benefits for a production and design engineer and then compares the payroll tax and benefit-related costs for this average worker on an employee versus contractor basis. His results are tabulated as follows:

Accounting Category
Hi-Tech’s Books
as Employee
Hi-Tech’s Books
as Contractor
Pay for time worked
$50,000
$50,000
Pay for time not worked (vacations, etc.)
    5,000
             
Base wages
55,000
50,000
Employer’s FICA (7.65%)
4,208
 
Employer’s FUTA (0.8% on first $7,000)
56
 
Worker’s compensation (1.2% of base wages)
660
 
Retirement, fringe and welfare benefits (estimated) at 35% of base wages)
  19,250
             
Total
$79,174
$50,000

In preparing this table, the bookkeeper assumes that (1) the hourly wage rate remains fixed (in reality, an independent contractor may try to increase the hourly rate to recover some lost benefits); and (2) all retirement, fringe, and welfare benefits are funded solely by Hi-Tech.

As the table demonstrates, the estimated cost of hiring a person as an independent contractor can be significantly less than hiring such person as an employee—and this is strictly tax and benefit savings. The value of other factors, including administrative time and compliance efforts, and state unemployment tax, are not included in this comparison.

In today’s competitive marketplace, companies are looking for ways to reduce the cost of doing business. Understandably, the opportunity to cut total labor costs by half or more often proves irresistible. Classifying a worker as an independent contractor can simply be too good to pass up.

The IRS estimates millions of workers are misclassified as independent contractors, depriving the federal government of huge sums of tax revenue because of underreported income and related unpaid employment taxes. To combat this, worker classification is a primary issue in most payroll audits.

Negative Aspect of Using Independent Contractors
For tax years beginning after 2004, the American Jobs Creation Act of 2004 authorizes a deduction equal to a percentage of the income earned from manufacturing and certain other production activities within the U.S. (IRC Sec. 199). The deduction equals 3% (for 2006 and 6% for 2007) of the lesser of the taxpayer’s (1) qualified production activities income for the tax year, or (2) taxable income, determined without this deduction. However, the allowable deduction may not exceed 50% of the taxpayer’s Form W-2 wages for the year that are property allocable to domestic production gross receipts. Therefore, using independent contractors instead of employees can limit the taxpayer’s deduction under IRC Sec. 199.

Strengthening the Case for Independent Contractor Status
Independent contractor relationships must be closely monitored to ensure they will withstand IRS scrutiny.

Caution: The IRS feels that the improper classification of employees as independent contractors has made the problem of unreported income a significant one and, therefore, it recently reminded businesses and employers to classify workers correctly to ensure that all tax obligations are met. The IRS recently announced that it is moving ahead with initiatives in several employment tax areas to increase collection amounts—especially with worker classification. IRS officials have indicated that worker classification cases will be a major area of emphasis in 2008. The IRS has shifted more resources to address the problem of payments made to nonemployees to determine if they are legitimate and has entered into data-sharing agreements with several state workforce agencies to refer employment tax cases for audit.

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