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IRS and State Auditors Attack
Independent Contractors
Employee
vs. Independent Contractor Status is a hot area of IRS Audits.
The state taxing agencies, as
well as the Departments of Labor (which are responsible for
Unemployment tax collections) have been stepping-up their audit
activities. The purpose of the audit is to misclassify a subcontractor
as an employee. The taxing agency can then collect
the taxes which "should have been withheld" as well as large fines,
penalties and interest. Since a significant portion of the taxes are
so-called Trust Fund monies, the IRS and States hold
the shareholders, officers or other Responsible Parties
personally liable for the taxes.
Planning
makes the difference between winning and Losing!
You should immediately contact your tax lawyer to prepare the
Independent Contractor Contracts, Checklists, and other information
needed to have the subcontractor status stand up to an audit. The facts
of the relationship must also strongly support non-employee status. At
a minimum, you can not exercise dominion and control over the work of
the contractor. You can specify "what" is to be done but not "how."
Other important factors in determining independent contractor status:
- Does the subcontract use
his/her own tools. equipment and other capital items
- Does
the contractor have a business telephone number and yellow page listing
- Does
the contractor have a business card, letterhead, invoices, and other
printed items.
- Does
the contractor file tax returns (such as the 1040 Schedule C.)
The
Subcontractor should establish an LLC!
If the contractor operates as
a corporation or Limited Liability Company, the worker will most-likely
be classified as an independent contractor rather than an employee.
Even though it may be legally possible for an IRS or State tax auditor
to ignore the corporation or LLC, most frequently the auditor will not
challenge independent contractor status of a corporation or LLC.
The
LLC is Best
At one time, establishing an
"S" corporation was the best choice for proving subcontractor status.
Now, with the advent of single member Limited Liability Companies, the
LLC is the superior choice. Since the worker is filing a 1040 Schedule
C anyway as a sole proprietor, and will also file a 1040 Schedule C as
a single member LLC, other than the small cost of formation, the LLC is
not detrimental to the worker and strongly asserts the worker's
independent status.
Why is
the LLC the best protection of the Subcontractor Arrangement?
The reasons why Limited
Liability Companies and Corporations are usually affirmed in audits as
subcontractors:
- The LLC or Corporation is a
separate legal entity distinct from its owners
- The
LLC only operates through its managing members and the Corporation
through its directors and officers.
- Corporate
Officers are employees of the Corporation not the Business being
audited for employee / independent contractor issues.
- The
LLC requires the filing of a 1040 Schedule C
- The
corporation will issue a w-2 to the shareholder as an officer or
director, and the LLC member will pay self-employment tax
- The
business being audited therefore would not have to issue W-2's because
they were issued by the worker's corporation or the Schedule C was
filed for the LLC
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