The conflict between the IRS and businesses regarding who is an independent contractor and who is an actual employee is nothing new and will probably always be an issue. To keep your company as far from trouble as possible, get and keep yourself up to speed on the IRS rules regarding the use and classification of independent contractors.

Respective responsibilities

In the traditional employer-employee relationship, the employer is responsible for a number of tasks. These include:

• Withholding federal and state income taxes,
• Paying unemployment taxes (FUTA),
• Withholding the employee’s share of FICA and Medicare taxes, and
• Paying both the employee and employer portions of FICA and Medicare taxes.

Independent contractors are responsible for their own taxes. In addition to making estimated tax payments for their federal and state income tax liabilities, they’re subject to self-employment tax, which covers both the employer and employee shares of FICA. (They are, however, entitled to a deduction for the “employer’s” portion.)

IRS preference

Because it’s easier and cheaper to collect taxes from a single employer than from multiple independent contractors, the IRS has a strong preference for employee status. If the IRS reclassifies independent contractors as employees, it can go after your company for back taxes that should have been paid, payroll and income taxes that should have been withheld, and penalties and interest.

Additional penalties may apply if the IRS finds that you intentionally disregarded your tax obligations. And, of course, your state may impose penalties of its own. Finally, “responsible persons” — including certain officers, partners and managers — could be personally liable for uncollected taxes.

Even if workers you treat as independent contractors have paid their taxes, you’re not necessarily safe. If the IRS finds they should have been classified as employees, it still may hit you with penalties equal to 20% of your tax liability.

Key factors

The simplest way to avoid these consequences is to treat workers as employees unless they clearly qualify as independent contractors. The IRS typically examines and weighs 11 factors to determine whether a worker is an employee or independent contractor. These considerations indicate to the agency the degree of control exercised by the employer and the degree of independence of the worker.

For instance, the IRS looks at behavioral control such as instruction (employees usually receive detailed instructions about when, where and how to work) and training (employees often receive training on how to perform their job duties).

The type of relationship is also important. Does the individual receive benefits? Is he or she working for the business indefinitely? Are his or her services critical to the company’s ongoing operations? Affirmative answers to any or all of these questions would bolster an IRS case that the person in question is an employee, not an independent contractor.

Another important issue is financial control. The IRS will look for unreimbursed business expenses, which are usually incurred by independent contractors, not employees. Independent contractors often make significant investments in facilities and equipment as well. Employees don’t.

In addition, employees are usually paid by the hour, week or some other period. But independent contractors generally receive a flat fee or submit an invoice for services. So method of payment is a key consideration. Independent contractors will also often continue marketing themselves while working on a given project and risk suffering a profit loss on every job.

Ultimately, no one factor controls the outcome. You need to examine and weigh all the factors to determine whether a particular worker is an employee or independent contractor.

Not a bad idea

Engaging independent contractors to fulfill targeted roles in specialized areas of your business isn’t a bad idea. They may be less costly because you don’t have to pay benefits and payroll taxes. But you must carefully evaluate how much risk there is that the IRS could reclassify them as employees.

The 2012 tax year has begun with many familiar tax regulations in place.  Lawmakers have extended various Bush-era tax cuts through the end of the year.  Other provisions – such as the “patch” for Alternative Minimum Tax (AMT) and the R&E Tax Credit – are likely to be extended.  While there is much discussion in Congress about new provisions for both individuals and businesses, little is expected to be accomplished until after the November elections.  Assuming no changes are made to the tax law, the 2013 tax landscape is going to differ greatly from 2012.

The top income tax rate, 35% for 2012, is set to increase to 39.6% starting in 2013.  For 2012, long-term capital gains and qualified dividends are being taxed at 15%, but that is all set to change in 2013.  Starting in 2013 long-term capital gains will be taxed at 20% and qualified dividends will be taxed at ordinary tax rates (potentially 39.6%).  In addition, 2013 brings the new Medicare tax of 3.8% on investment income as well as an additional 0.9% Medicare tax on wages for married taxpayers making over $250,000 ($200,000 if single).  Those with “high income” will also see a return of the limitation on total allowable itemized deductions and personal exemptions.

Business owners should also keep in mind that depreciation deductions are set to decrease with the eliminations of bonus depreciation and reduction of allowable Section 179 expense.  Taxpayers who have benefited from these in the past will have little to no depreciation expense from assets bought in the past few years.  At the same time they will not have the ability to take a 100% write off for newly purchased assets.  It will all add up to a much lower depreciation expense and a much larger tax bill in 2013, even if there is not much change in business activity or cash flow, for capital intensive businesses.

The upcoming elections have already affected the current tax code and we can be sure they will play a large roll in influencing key decisions for 2012 and beyond.  While the above addresses what is currently scheduled to happen in 2013, the presidential candidates each have proposals that would affect the 2013 tax landscape.  In addition, the party who is in control of Congress will help determine whether the proposals of the elected candidate have a chance to become law.

President Obama is currently proposing tax rate increases and some major changes to itemized deductions for higher income taxpayers. For those not considered high income (families earning less than $250,000, singles earning less than $200,000) he would extend much of the current tax law.  In effect, the high income taxpayer would pay more in order to keep much of the current tax law in place for everyone else.

Romney’s 2013 tax proposals include the elimination of AMT, as well as elimination of tax on investment income for married taxpayers with income under $200,000.  He is proposing a reduction in all tax rates, with a top ordinary tax rate of 28%, and the elimination of the estate tax.

So what can you do now to plan for 2012 and beyond?  Below are some things you may want to consider before the end of 2012 in order to save tax.

Acceleration of ordinary income.  The top total effective rate for 2013 could reach 44.6% after considering the phaseout of certain deductions and the new Medicare tax.  This is a dramatic increase from where we stand today.  With the top ordinary tax rate for 2012 at 35% it may make sense for taxpayers to accelerate ordinary income from 2013 into 2012.  This could be accomplished by receiving income prior to year end, as well as deferring deductions into 2013.

Capital gain harvesting.  The top long-term capital gain tax rate for 2012 is 15%.  While that rate is scheduled to increase to 20% in 2013, the total effective tax rate could be closer to 25% with the changes mentioned above.  Most taxpayers have heard of the practice of harvesting capital losses.  2012 creates a unique opportunity to harvest capital gains.  By selling stock in 2012 and paying tax at 15%, taxpayers could realize significant tax savings.  In addition, stocks sold at a gain are not affected by the “wash sale” rules, so a taxpayer could re-invest in these same investments without waiting 30 days.

Significant dividend payments. If you are the owner of a C-Corporation, or an S-Corporation with prior C-Corp earnings, making dividend payments in 2012 instead of 2013 could provide very significant tax savings.  For 2012 qualified dividends are taxed at 15%.  Starting in 2013, qualified dividends will be taxed at ordinary rates.  As mentioned above, the total effective tax for higher income taxpayers could reach 44.6% on these dividends.

Taxpayers should not wait for the election results to begin planning.  Now is the time to sit down with your key advisors and develop plans based on what is known, as well as what could happen as a result of the elections.  The items mentioned in this article are only a few of the significant changes which are either currently in the law or being discussed.  Also, keep in mind that everyone’s situation is different.  While using one of the ideas mentioned above may be a good course for most taxpayers, it may not fit your specific situation.

When the election results do come in, be sure to be paying attention.  A shift in power to the left or the right could yield much different tax implications in the future.

See What Brien Has to Say

Why it matters

The Internal Revenue Code (IRC) generally allows you to claim passive-activity losses only against income from other passive activities. If your passive losses exceed your passive income for the year, you can carry the losses forward until you either have enough passive income to absorb them or you dispose of the activity, in which case you’re generally allowed to deduct the losses against nonpassive income.

“Passive activity” is defined as any trade or business in which the taxpayer doesn’t participate on a regular, continuous and substantial basis (also known as “material participation”). Rental real estate activities are usually considered passive activities regardless of whether you materially participate — unless you qualify as a real estate professional. Then rental activities are treated as a trade or business, and losses from the activity aren’t considered passive, so you can deduct them against nonpassive income.

The stumbling block

A taxpayer qualifies as a real estate professional by satisfying two requirements. First, more than 50% of the personal services the taxpayer performs in trades or businesses must be performed in real property trades or businesses in which he or she materially participates. Second, during the tax year the taxpayer must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.

Under the IRC, a taxpayer’s interests in rental real estate generally will be treated as separate activities when determining whether the taxpayer materially participates in each rental real estate activity — unless he or she elects to treat all interests in rental real estate as a single rental real estate activity.

To make this election for a particular tax year, you must file a statement with specific information along with your income tax return. Taxpayers failing to make the election on their returns can seek an extension of up to six months by obtaining a letter ruling from the IRS.

However, this is a burdensome process. The taxpayer must, for example, file a “complete statement of facts and other information,” include copies of relevant documents, and provide an analysis of material facts and statements of authorities supporting and opposing the taxpayer’s position. The letter ruling request may also be subject to a user fee and a statute of limitations. After its review, the IRS may request additional information to make a determination.  The process can take months from start to finish.

An easier way to make late elections effective

1.  The IRS has now outlined special procedures, in lieu of the burdensome letter ruling procedure, for obtaining the tax benefit despite not making a timely election. To be eligible, a taxpayer must show the following:

2.  He or she failed to make the election solely because of failure to timely meet the election requirements.

• He or she filed consistent with having made an election on any return that would have been affected had the election been timely made — that is:
• The returns must have been filed “as if” the election had been made on a timely basis,
• The taxpayer must have filed all required federal income tax returns consistent with the requested aggregation for all of the years under scrutiny, and
• Once the election is made, all future returns must be filed using aggregation unless the taxpayer no longer qualifies for aggregation or subsequently revokes the election.

3.  He or she timely filed each return that would have been affected by the election if it had been timely made. (For these purposes, “timely” means that the return was filed within six months of the due date, excluding extensions.)

4.  There is reasonable cause for the failure to meet the requirements for the election (for example, reasonable reliance on the written advice of the IRS).

The procedure contains specific requirements for requesting relief for late elections. For example, you must attach a specific statement to an amended return for the most recent tax year, and the statement must contain a particular declaration, explain the reason for failing to file a timely election, and include certain representations.

Making the election

If you haven’t made the election to treat all real estate activities as one activity, check with your tax advisor. If you’re in need of retroactive relief, he or she can help ensure that you satisfy all of the various requirements to potentially receive an income tax refund.

What are the requirements?

Generally, plans appoint a fiduciary, typically the trustee, to ensure that all contributions are deposited into the plan in a timely manner. Larger retirement plans — those with 100 or more participants — must deposit employee contributions as soon as administratively feasible, but no later than the 15th business day of the following month.

The DOL gives smaller retirement plans (those plans consisting of fewer than 100 participants as of the beginning of the year) a shorter period in which to make deposits. Under the DOL’s safe harbor, plans must make deposits no later than the seventh business day following the date in which the amounts would have been paid to an employee as compensation.

What are the consequences?

If you fail to make timely employee elective deferral contributions, you’ll be considered to have engaged in prohibited use of plan assets, otherwise known as a prohibited transaction. The initial excise tax on a prohibited transaction is 15% of the amount involved for each year in the taxable period. If you don’t correct the transaction within the taxable period, the DOL will impose an additional tax equal to 100% of the amount involved.

What should employers do?

Employers should perform self-audits to make sure their plan complies with DOL regulations. Regularly review your plan document provisions on timely deposits of elective deferrals.

Then, work with your payroll provider to compare the earliest date that you can segregate elective deferrals from assets to the actual deposit dates. This can help determine if you’re depositing the contributions timely.

How can you correct a mistake?

Employers can make corrections and avoid excise taxes using the DOL’s Voluntary Fiduciary Correction Program (VFCP). Under the program, you must restore the principal amount to the plan, plus the greater of:

• Lost earnings, from the date of the loss to the recovery date, or
• Profits resulting from the use of the principal amount from the date of the loss to the date the profit is realized.

You must pay all expenses associated with correcting transactions, such as fees associated with recalculating participant account balances. Finally, you must make any additional distributions if necessary to former employees, beneficiaries or alternate payees.

The DOL has a calculator available on its website to assist with the lost earnings calculation.

How to avoid the mistake

If you have personnel changes, make sure the new staff members have a full understanding of how and when to make deposits into a qualified retirement plan. Making timely deposits will not only avoid taxes and penalties, but it could also save the plan from potential disqualification.

Part. 1 Current Developments 

• Experts’ Forum

Part. 2 Individual Taxation

• Sustaining Management Fees for Commonly Controlled Entities
• JCT Analyses Charitable Contributions
• IRS Updates ATG on Lawsuits, Awards, and Settlements

Part. 3 Business Taxation

• Tax Considerations for Corporate Aircraft
• IRS Releases Schedule UTP Guidance for Examiners
• Final Regulations on Payroll and Excise Taxes of Disregarded Entities
• Trust Treated as Collectively Bargained Welfare Benefit Fund
• Fifth Circuit Rules on Correction of Accounting Method

Part. 4  Special Topics:  Exempt Organizations

• Private Foundation’s Plan to Support Nonprofit College Prep School
• Members’ Legal Right to Publications and UBIT
• IRS Guidance for Credit Counseling Organizations

Part 1.  Accounting Practice

• ASU 2011-12

Part 2.  Auditing Practice

• AUP Engagements

Part 3.  Small Business Practice

• The Independence and Ethics Alert

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