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Employees, contractors and taxes

By Kay Bell ·
Tuesday, November 29, 2011
Posted: 5 pm ET

You got a job for the holidays. That extra cash certainly will come in handy. But be careful, or you could end up paying more than you expected to the IRS.

Many businesses nowadays are hiring folks as independent contractors rather than as employees. The distinction makes a big difference in who's responsible for income tax payments.

If you're an employee, you'll have income and Social Security and Medicare taxes, commonly referred to as FICA, taken out of your paycheck via payroll withholding.

But if your boss classifies you as a contractor, then you're responsible for paying all those taxes. That means you'll get a bigger paycheck, but then you'll have to give the income taxes and FICA payments back to the IRS yourself.

So make sure both you and your boss are clear on your employment status.

Contractor benefits to businesses: Companies like using contractors instead of hiring employees because from a tax perspective, it saves them money.

Not only do they avoid the administrative hassle of withholding taxes, but the businesses also don't have to pay their portions of Social Security, Medicare or federal unemployment taxes on payments to independent contractors.

That's why the IRS and Department of Labor recently stepped up their oversight into worker classifications.

This fall the two federal agencies entered into an agreement, along with 11 states (Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, New York, Utah and Washington), to make sharing of employee classification data easier.

The IRS then followed that agreement up with a new program that will let eligible employers resolve worker misclassification issues more easily.

Under the IRS's new Voluntary Classification Settlement Program, or VCSP, when a company is found to have misclassified workers as contractors, the workplace can simply correct the error, reclassifying the workers in exchange for significant relief from past employment taxes, penalties and interest and the avoidance of an IRS audit.

Companies that don't participate in the VCSP and then are found to have carried workers as contractors instead of employees can expect to feel a much heavier IRS hand.

They will face employment audits, which can result in the offending companies owing not only more taxes, but associated penalty charges for failure to file W-2 forms and furnish them to workers, deposit taxes, late payments and negligence. And there is, of course, also the added interest.

What about the workers? There are several ways to determine whether someone is an employee or a contractor, but the key factor is what the IRS calls behavioral control.

If the company has the right to control or direct what you do as part of your job, as well as how you do it, then you are most likely an employee.

If, however, the company only dictates work result but not how you accomplish the work product, then your control makes you an independent contractor.

If you're carried as a contractor but believe you should be properly considered an employee, let the IRS know.

In the meantime, set aside some of your earnings so you can pay estimated taxes on your earnings. That will keep you out of the IRS cross hairs.

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