INDEPENDENT CONTRACTORS

Hiring Independent Contractors For Your Work Force Needs

Independent contractors are a popular choice for business owners to fill their work force needs. True independent contractors are not treated as employees, which essentially means that payroll taxes and certain state and federal employment laws do not apply to them. It's important, however, to ensure that a worker qualifies as an independent contractor because the repercussions for incorrectly classifying workers can be severe.

Many small business owners do not have the need or the desire to hire traditional employees to work for their business. The ones that do often only do so for the essential functions of their business. But even for these businesses there are times when a work force is required. It is for these situations that using independent contractors is a great solution.

What's so advantageous about hiring independent contractors? Hiring independent contractors allows you to have a work force only when and if you need it. With independent contractors, it's possible to have personnel to work on (or off) your premises without becoming subject to payroll taxes or to many state and federal employment laws.

Warning

Traditionally the government does not favor treating workers as independent contractors, so there are several complex federal tests involved to make sure that the person actually qualifies as an independent contractor and is not an employee.

Incorrect classification of employees as independent contractors is under intense scrutiny by both the Internal Revenue Service (IRS) and the Department of Labor (DOL). This is not an area where you can hope to fly under the radar, so be sure you're correctly classifying your workers to avoid costly fines and penalties.

Many consultants advise companies to contract out any function that is not directly related to the production of the company's core products or services. For example, many white collar-type businesses contract out their building maintenance work or food service functions.

Independent contractors are also particularly useful when you need a specific skill or technical knowledge for a special project that's expected to last a relatively short length of time.

If you think using independent contractors might be the right fit for your business, consider the following:

What, exactly, is an independent contractor? Which job categories might lend themselves to such treatment?
What are some pros and cons of using independent contractors?
What are some tips for successfully using independent contractors?

Defining an Independent Contractor

Independent contractors work for themselves — they are treated as if they are running their own business. Thus, you are not the employer of an independent contractor, and you aren't liable for payroll taxes or benefits for them, nor are they protected by workers' compensation or most labor laws.

Independent contractors control the performance of the work based on their experience, special license, or special education or training required for the job.

In most cases, you tell them the outlines of the project that needs to be done and the due date, and they determine how to accomplish it, on their own schedule. The independent contractor provides the knowledge, experience, and labor to perform the job or provides other individuals to perform the job contracted. Independent contractors are usually paid based on their results (i.e., a flat rate per job, or a per-unit-completed rate) rather than the time they put in.

IRS Rules. Generally speaking, for tax purposes the key question as to whether someone qualifies as an independent contractor is the degree of control you can exercise over the worker. The worker will be treated as an employee if the company has the right to determine not just what the employee does, but when, where, or how he or she does it.

The IRS has a 20-factor test that it uses to determine whether an employee is an independent contractor or an employee in disguise. The factors can carry different weights, depending on the factual situation. Generally speaking, if the worker would be considered an employee under at least 10 of the factors, you should treat him or her as an employee.

The IRS frowns on the use of independent contractors, in part because such workers are responsible for paying their own payroll taxes and it's much more difficult to make sure they're doing so.

If in doubt, look at IRS Form SS-8, which is the form used by the IRS to determine individual status for purposes of income and employment taxes.

Fair Labor Standards Act (FLSA). The Fair Labor Standards Act (FLSA) is another important federal law governing your treatment of workers. Unfortunately, it has its own definition of independent contractor that is slightly different from the IRS's definition.

In order to be truly sure that you're safe in treating workers as independent, you must meet both definitions.

Under the FLSA, independent contractors are not employees and are, therefore, not entitled to minimum wage and overtime protections. There are six factors for determining whether a worker is an employee under the FLSA, as opposed to an independent contractor:

the degree of the alleged employer's right to control the manner in which the work is performed
the alleged employee's opportunity for profit or loss depending upon managerial skill
the alleged employee's investment in equipment or materials required for the work
whether the service rendered requires special skills
the degree of permanence of the working relationship
whether the service rendered by the worker is an integral part of the alleged employer's business

No single factor is more important than the others in determining independent contractor status. When the issue comes up in courts, the judge must consider whether, as a matter of economic reality, a worker is dependent on the business to which a service is rendered for continued work. The greater the dependence, the more likely the worker will be found to be an employee.

Independent contractor agreements. It's extremely important to realize that having a worker sign an independent contractor agreement will not automatically create such status if the worker does not meet the requirements of the tests described above.

Tip

Although an independent contractor agreement does not create the status, when working with independent contractors, it is a good idea to develop a written contract relinquishing the right to control and specifying that the worker will not be treated as an employee for federal tax purposes. Employers should also file informational returns (1099 MISCs) for their independent contractors and comply with state laws for workers' compensation and unemployment compensation.

A contract with an independent contractor should also include terms on terminating the relationship. Because independent contractors are not employees, termination would be done according to the provisions of the contract. Since a firm and an independent contractor have a contract relationship, not an employment relationship, any misunderstandings about job performance or termination of the relationship are governed by contract law.

What is the status of workers employed by an independent contractor?Workers employed by an independent contractor are not employees of the organization which the contractor is serving — they are employees of the contractor.

Pros and Cons of Using Independent Contractors

There are numerous advantages to using independent contractors for your staffing needs, but you should be aware of the disadvantages that exist as well.

Using independent contractors offers employers significant tax and non-tax advantages. Since employers are required to pay certain benefits and taxes on behalf of their employees, the financial benefits of having a large independent contractor work force can be significant.

For example, by classifying workers as independent contractors, employers may be able to avoid responsibility under:

the Federal Insurance Contribution Act (FICA) or Social Security tax
the Federal Unemployment Tax Act (FUTA)
the Consolidated Omnibus Budget Reconciliation Act (COBRA)
workers' compensation
retirement plans

All payroll taxes and benefits are maintained by the individual contractor, who does not participate in your company-offered benefit plans.

Also, your own exemption from many federal and state employment laws is based on how many employees you have in your work force. Independent contractors are not counted as employees. Thus, if you contract with independent contractors instead of hiring regular full-time employees, you may not be covered by some of these laws. These laws include:

the Americans with Disabilities Act
the Family and Medical Leave Act
Title VII of the Civil Rights Act of 1964
the Age Discrimination in Employment Act

Disadvantages of independent contractors. The main disadvantage to using independents is that you must keep on top of exactly what qualifies someone as an independent contractor. If you classify someone as an independent contractor who isn't, the penalties can be extremely costly.

In addition, independent contractors, by definition, are permitted to work for a number of different companies at a time. You won't have as much control over the worker's time, efforts, and loyalty as you would with a permanent employee.

Furthermore, some contracts permit the independent contractor to substitute another individual for himself or herself on any job, so you may not even be sure who's ultimately going to do the work for you.

Finally, independent contractors make a commitment to work for you for the length of the contract, and that's it. If you like their work and want to continue the relationship, you may have to renegotiate the agreement (including their payment rate).

Tips for Using Independent Contractors

You should be aware that there are various steps you can take to facilitate your use of independent contractors. Here are some things you can do to help ensure that those who work for you qualify for independent contractor status and that you can win any challenges to your arrangements:

Be careful, when advertising for independent contractors, to avoid using phrases such as salary, wages, or steady work when you are recruiting. Try looking for independent contractors who have placed their own ads under "Situations Wanted" or "Trade Services."
When establishing the relationship, avoid setting a regular pattern of daily or weekly hours. A self-employed individual presumably has the opportunity to select when and where he will work in relation to all his customers.
Allow contractors to supply their own tools, supplies, and equipment wherever possible in the performance of the services required. This will demonstrate that there is a risk of loss as well as an opportunity for profit.
Use contractors who normally advertise their services in some manner. Keep on file any business cards, circulars, or even telephone directory ads.
Allow contractors to hire their own assistants, if necessary. Insist that the contractor pay the payroll taxes normally required for such employees.
Don't include contractors under the insurance coverage for workers' compensation, health insurance, or other benefits that are provided for employees.
If possible, compensate such independent contractors on a per-job basis rather than by hour or by week.
Always ask for an invoice or statement before paying for any work that has been performed. If possible, make checks payable to a company rather than to an individual.
Do not directly reimburse contractors for any expenses they might have, for gasoline, meals, etc. Such expenses should stand as part of the contractor's set fees.
Remember that in theory you cannot discharge a contractor from employment. If dissatisfied with a contractor's performance, look to your contract for a remedy. If there is no contract, sever relations with the contractor by offering no more work.
Put it in writing! It is best, of course, to have a contract in writing with an independent contractor. This can be used on your behalf to demonstrate the validity of an independent contractor relationship, although it isn't conclusive evidence of one.

Tools to Use

The Business Tools include a sample independent contractor agreement for your use.

In many states, an agreement is required in order to establish an independent contractor relationship.

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No Money, No Problem: Refundable R&D Tax Credit Opportunities for Startups and “Small” Businesses

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October 13, 2017

The federal research and development tax credit was finally made permanent in late 2015 under the Protecting Americans from Tax Hikes (PATH) Act. With this legislation, Congress introduced changes to the research credit that are beneficial for taxpayers who previously may not have been able to take advantage of this incentive. For tax years beginning after December 31, 2015, the PATH Act added new Section 41(h) to the Internal Revenue Code, which provides qualified small businesses with a payroll tax offset and allows companies to receive a benefit for their research activities regardless of whether they are profitable.

Generally, many small startups and businesses operate at a loss and are unable to attain a current cash benefit from the federal research credit because the credit could be used only to offset federal income tax liability. With the new payroll tax offset, the R&D tax credit is now available to many small and mid-sized companies that had been effectively barred from using the credit. In 2017, qualified businesses began benefitting from the new payroll tax offset by utilizing 2016 R&D expenditures to offset a portion of their payroll taxes.

Payroll Tax Offset

Under Sections 41(h) and 3111(f) of the Internal Revenue Code, new or small businesses may be eligible to apply up to $250,000 annually of their research credit against the employer’s Social Security portion of their old-age, survivors and disability insurance (OASDI) payroll tax liability. Eligible small businesses can potentially claim the credit for up to five years with a maximum of $1.25 million in total credits claimed on their quarterly payroll tax returns filed with the federal government.

The new payroll tax offset represents a highly beneficial incentive for cash-strapped technology startups, which are typically not taxable and frequently uninterested in long-term carryforwards. Companies may be eligible to apply the R&D tax credit against their payroll tax beginning in the first full quarter after an income tax return is filed with the Section 41(h) election. However, these companies must meet the definition of a “qualified small business.”

On March 28, 2017, the IRS released Notice 2017-23 to provide interim guidance and clarify small business eligibility. The Notice indicates that to be defined as a “qualified small business,” a taxpayer must have (1) gross receipts of less than $5 million in the year in which it seeks to make the election and (2) no gross receipts for any tax year before the five years ending with the election year. As a result, a company that was in existence prior to the five years, but did not have gross receipts, could still qualify. Furthermore, gross receipts of over $5 million for any of the four years prior to the credit years are allowed.

Notice 2017-23 provides the following example to clarify the application of the payroll tax offset:

Corp A, a calendar-year corporation, is not a tax-exempt organization under Section 501 or a member of a controlled group in taxable year 2016.
Corp A has gross receipts of $1 million, $7 million, $4 million, $3 million, and $4 million for taxable years 2012, 2013, 2014, 2015, and 2016, respectively.
Corp A did not have gross receipts for any taxable year prior to 2012.
Corp A is a qualified small business for taxable year 2016 because it has less than $5,000,000 in gross receipts for taxable year 2016 and did not have gross receipts before taxable year 2012 (before the five-taxable-year period ending with 2016).
Corp A’s gross receipts in taxable years 2012-2015 are not relevant in determining whether Corp A is a qualified small business in taxable year 2016.
Because Corp A had gross receipts in taxable year 2012, Corp A is not a qualified small business in taxable year 2017, regardless of its gross receipts in 2017.

The Notice clarifies that “gross receipts” include total sales, net of returns and allowances, all amounts received for services, and any income from investments and other incidental or outside sources. This inclusive definition means that taxpayers with even small amounts of investment income or interest prior to 2012, if the tax year is 2016, may not elect the payroll offset. This is significant because it limits taxpayer eligibility, specifically for companies that had been in existence prior to 2012.

Payroll Tax Offset — Controlled Groups

Notice 2017-23 provides guidance for members of a controlled group regarding aggregation and allocation of the benefit. All members of a controlled group or a group of trades or businesses under common control, as defined in Section 1.41-6(a)(3)(ii), are treated as a single taxpayer. The aggregate gross receipts of all members of a controlled group for the taxable year must be considered when determining whether the requirements of the Notice are satisfied.

The special rules for consolidated groups would require each taxpayer to consider all related parties (foreign and domestic) that fit the ownership requirements for purposes of applying the gross receipts measurement. This could potentially limit the applicability of the payroll tax credit election for some taxpayers.

What Forms Are Required to Claim the Payroll Tax Offset for R&D?

Form 6765, Credit for Increasing Research Activities with 41(h) and 280C elections. Note that for purposes of the payroll tax offset, the taxpayer will not want to choose the 280(C) election on Form 6765.
Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities
Form 941, Employer’s Quarterly Federal Tax Return
Forms 6765 and 8974 must accompany Form 941

The portion of the R&D credit that is applied to offset payroll taxes needs to be identified and elected when the tax return is filed. The payroll tax offset is available on a quarterly basis beginning the first calendar quarter that begins after a taxpayer files their federal income tax return.

Taxpayers have the option of making a reduced credit election under Section 280C(c)(3) in lieu of adding their research credit back to taxable income in the form of a reduced Section 174 deduction. This is important because if the 280C reduced credit election is made before the 41(h) election, taxpayers will be denied the full value of their $250,000 credit against OASDI payroll tax liability. For purposes of Section 41(h), the payroll tax offset is allowed before the election, so most taxpayers should not elect 280C when claiming the payroll tax offset.

Notice 2017-23 further explains that if the R&D tax credit exceeds the payroll tax due on a quarterly filing, the excess may be carried over to succeeding calendar quarters until the credit is used or the $250,000 limit is reached. In addition, the Notice enables taxpayers who failed to elect the payroll offset on their original returns for 2016 to take advantage of the provision by filing an amended return on or before December 31, 2017.

Professional Employer Organizations

Many companies use a professional employer organization (PEO) to streamline their payroll function. The IRS created a voluntary certification program for PEOs and provides guidance stating that once certified, PEOs may process the payroll offset claims for their clients. It is important to note that it is the company conducting qualified research, and not the PEO, that receives the payroll offset.

Alternative Minimum Tax

As part of the PATH Act, Section 38(c)(4)(B) was amended to allow “eligible small businesses” to use their research credit as a “specified credit” to offset Alternative Minimum Tax (AMT). Under this legislation, the research credit is now available to taxpayers falling under the AMT regime. Generally, the amount of R&D credit taxpayers can claim in any given year is limited by the amount of tentative minimum tax they owe. However, the PATH Act permits eligible small businesses to use credits to fully offset their tax liability without regard to the tentative minimum tax.

To be considered an eligible small business, a taxpayer must be a non-publicly traded corporation, partnership or sole proprietorship, and cannot have average annual gross receipts in the three preceding tax years in excess of $50 million. The credit amount is limited to 25 percent of the taxpayer’s net regular tax liability in excess of $25,000. As a result, taxpayers will not be able to take their tax liability all the way down to zero.

Who Benefits?

Non-taxable startups are typically not concerned about a 20-year carryforward that might never result in cash tax savings. However, deducting $250,000 of payroll tax liability beginning with the 2016 tax year is a different story. Section 41(h) provides a clear benefit to startups founded within the last five or six years that otherwise might not be able to take advantage of — or perhaps see any value in claiming — the R&D tax credit.

The new AMT offset rules under Section 41(h) provide relief for slightly more mature startups, small to mid-sized companies, and owners of passthrough entities that, but for the AMT regime, might not otherwise be taxable.

Companies that can claim the payroll and AMT offset come from a variety of industries, all of which are designing new products or making incremental improvements. These industries include the biotech, chemistry, agriculture, technology, software, manufacturing, wine, oil & gas, aerospace subcontracting, pharmaceutical, and pre-release medical device industries. This credit provides a cash benefit that should be claimed by every eligible company.

Alvarez & Marsal Taxand Says:

With the new interim guidance, taxpayers have more certainty in electing R&D tax credits to offset their payroll tax starting in 2017. However, issues such as timely filing and the precise definition of gross receipts contribute to uncertainty with respect to successfully claiming the R&D benefits provided by the PATH Act. Taxpayers that are considering claiming these credits should carefully consider timely filing (i.e., file by the end of the quarter). Due to Social Security tax limitations, most companies pay a greater amount of tax in their earlier quarters than later ones. Therefore, the smaller the company (i.e., the smaller its annual payroll), the quicker that company must file its returns in order to obtain the full $250,000 benefit in a given year.

Although the law is intended to benefit small businesses, larger businesses could potentially benefit under the rules as they are currently written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives U.S. Food and Drug Administration approval. If you think your company might be performing work that qualifies for the R&D tax credit, don’t let the potential tax savings go unclaimed.

Disclaimer

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand

Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisers in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

To learn more, visit www.alvarezandmarsal.com or www.taxand.com

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