Employers have long preferred to treat workers as independent contractors, reaping payroll tax savings and avoiding any fringe benefits and other expenses associated with employees. By the same token, workers — including the owners of many pond and water feature businesses — could potentially lower their own tax bills by shifting from being an employee to independent contractor.
However, garden pond retailers, distributors, builders and manufacturers attempting to reduce costs by using independent contractors need to be sure that these workers really aren’t employees. And, while the 2017 Tax Cuts and Jobs Act (TCJA) contains a special 20-percent deduction from the income of independent contractors operating pass-through businesses such as S-corporations, LLCs and partnerships, newly proposed rules could make it harder for moderate-income employees, especially employees of their own businesses.
The TCJA, as mentioned, included a new 20-percent deduction for pass-through income from S-corporations, LLCs and partnerships — but it’s also available to independent contractors. Under the TCJA, many workers, as well as many business owners, are eyeing the lower tax bills that might result from shifting from being an employer to an independent contractor.
Obviously, this is not an easy decision. First, the 20-percent deduction from pass-through income generally occurs so long as taxable income is less than $157,500 for an individual or $315,000 for those filing jointly. What’s more, switching to independent contractor status might mean the loss of valuable benefits, such as retirement contributions, health insurance, unemployment benefits and workers’ compensation coverage.
Further restricting the 20-percent deduction for pass-through income, the IRS has said that if a worker was treated as an employee prior to the passage of the TCJA, then he or she is presumed to be an employee and cannot become an independent contractor for doing essentially the same work for the same employer.
Under recently proposed pass-through rules, most employees would be out of luck, and many high-income owners of service businesses would be getting an unexpected tax break. Owners of all pass-through businesses with income less than the limits are already permitted the 20-percent deduction. Thus, the new relief may benefit only very high-income owners.
The owners of small garden pond businesses who want to treat workers as independent contractors -— and those pond professionals wishing to operate as independent contractors -— need to be sure they aren’t, in reality, employees. Federal and state government agencies are on the lookout for businesses that use independent contractors or freelancers to evade Social Security, Medicare, unemployment taxes, workers compensation and disability insurance.
Typically, an employer will claim a worker as an independent contractor, while the IRS classifies the worker as an employee. The stakes for employers are high, and if a worker is treated as an employee, the employer must pay its share of taxes based on the Federal Insurance Contribution Act (FICA) and the Federal Unemployment Tax Act (FUTA).
Conversely, if a worker qualifies as an independent contractor, the employer isn’t responsible for those payroll taxes. Even more importantly, perhaps, the employer doesn’t have to provide expensive fringe benefits like health insurance or matching 401(k) contributions for those individuals.
What Constitutes ‘Independent’?
Although there are no absolute rules for determining who is and who isn’t an independent contractor, the IRS has published valuable guidelines. Generally, a worker doesn’t qualify as an independent contractor if he or she performs services that are controlled by the employer.
Who, for example, determines where and when the worker is at work? How closely is the worker supervised? Who purchases tools and supplies? Can the worker do work for other people or businesses? Is the worker paid by the hour, weekly or over another time period, or does the worker instead receive a flat fee?
Fortunately, the IRS looks at the totality of circumstances. In other words, if all the criteria point toward the worker being an independent contractor, the fact that the worker is paid by the hour won’t necessarily turn this into an employer-employee relationship.
No less a body than the U.S. Supreme Court has said that there is no definition that solves all problems relating to the employer-employee relationship under the Fair Labor Standards Act (FLSA). The Court has also said that the “determination of the relationship cannot be based on isolated factors or upon a single characteristic, but depends upon the circumstances of the whole activity.” In general, an employee, as distinguished from an independent contractor who is engaged in a business of his or her own, is one who “follows the usual path of an employee” and is dependent on the business that they serve.
The IRS formerly used a “20 Factor” test. Today, under pressure, the IRS has attempted to simplify and refine the test, consolidating the 20 factors into 11 main tests and organizing them into three main groups:
- Behavioral. Does the client or customer have the right to control what the worker does and how the worker does his or her job?\
- Financial. Are the business aspects of the worker’s job controlled by the payer? This includes such things as how payment is made, whether expenses are reimbursed and who provides tools and supplies.
- Type of Relationship. Are there written contracts or employee-type benefits like a pension plan, insurance, vacation pay, etc.? Will the relationship continue, and is the work performed a key aspect of the client or customer?
Obviously, there is no magic number of factors that defines whether an individual is an independent contractor or employee. The key is to look at the entire relationship, consider the degree or extent of the right to direct and control and, finally, document each of the factors used to produce the proper label of worker or independent contractor.
If there is any doubt remaining after reviewing the three categories of evidence, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS by either the pond professional or the business utilizing his or her services. Unfortunately, the IRS’s review of the facts and circumstances can take at least six months to reach a determination.
Pass-Through vs. Independent
For years, conventional wisdom dictated a business should operate as a pass-through entity because that avoided the dreaded double taxation problem of corporations (i.e., corporate profits are taxed at the corporate level and again when passed to shareholders as dividends). While the double taxation threat still exists after the TCJA, it has been toned down by the new 21-percent corporate tax rate.
Nothing in the TCJA discourages the time-honored strategy of operating as an S-corporation and paying modest salaries to shareholders and employees in order to minimize Social Security and Medicare taxes. In fact, the TCJA makes this strategy even more attractive for many pond business owners, because it maximizes the amount of pass-through income that is potentially eligible for the qualified business income deduction.
Unfortunately, as mentioned, the IRS’s new pass-through income deduction rules make it more difficult for moderate-income employees to lower their taxes by becoming an independent contractor. Higher-income owners of service businesses, on the other hand, could shrink their tax bill under the new rules.
Although independent contractors are a longtime, proven way for employers to achieve workforce flexibility and save money, they are also a popular strategy that provides pond professionals with a great deal of flexibility and, in some cases, lower tax bills for those choosing independent contractor status for themselves. Those lower tax bills and the difficulty in determining who is and who isn’t an independent contractor help explain the IRS’s ongoing crackdown on worker misclassification.
Fighting the Fight
The Government Accountability Office estimates that worker misclassification costs the federal government $2.7 billion per year, while both the IRS and the U.S. Department of Labor (DOL) believe that up to 30 percent of employers are misclassifying workers.
A pond business can be randomly audited, or federal or state officials could be tipped off to possible misclassification in other ways. If there is anything suspicious about the Form 1099s sent to independent contractors, the IRS is usually eager to investigate further. State officials often look at unemployment tax payments. If an independent contractor sues the business, the government might want to investigate.
Just as every pond and water feature business should be very careful to distinguish between employees and independent contractors, so should every pond professional who chooses independent contractor status as a pass-through entity. Professional assistance may be required to ensure you and your workers are clearly considered independent contractors.
Twenty-five years of professional experience in the fields of taxes and finance enable Mark Battersby to write on unique and topical subjects. Although no reputable professional should ever render specific advice at arm’s length, he does craft unbiased, interesting, informative and accurate articles. Mark currently writes for publications in a variety of fields. He also writes columns for trade magazines and has authored four books.