One of the biggest hurdles for a growing business is knowing when and how to hire employees once the business shows some success. It can be oh-so-tempting for entrepreneurs to consider hiring help and misclassifying independent contractors when really they are employees, or worse, paying for help “under the table.”
Both scenarios may seem like a good way to avoid paying payroll taxes and workers’ compensation insurance, but be careful here: Trying to avoid legal obligations when hiring is venturing onto shaky ground.
First, you need to determine whether the person you are hiring is truly an independent contractor. The Internal Revenue Service states that hired help can be determined as an independent contractor based on the degree of control you have within three categories:
• Behavioral. Does your company control or 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, including things such as who provides tools and supplies?
• Type of relationship. Are there written contracts or employee-type benefits, and will the relationship continue?
Still not sure? Go to www.irs.gov and fill out a Form SS-8 to have the IRS review your situation. This can be filed by the business owner or the worker.
If you’ve determined that you have an independent contractor, be sure to have that person fill out a W-9, document how much you pay them, and file a 1099-MISC at the end of the year. The 1099-MISC reports how much you paid them during the tax year and the independent contractor is then responsible for his or her own taxes. A copy of the 1099-MISC must be provided to the independent contractor by Jan. 31 of the next year.
Now let’s say you’ve determined that you don’t have an independent contractor situation but you have an employee. It may be tempting to pay “under the table,” but beware. This situation is likely to be a lose-lose for both parties involved.
“Even though paying workers cash may sound like a good deal for the worker because they’re often getting more in their pockets at payday, it means they’re not building Social Security benefits, and they’re not eligible for unemployment, or worker’s comp,” says Gretchen Henn, program director of the Maine Women’s Business Center at Coastal Enterprises Inc. “And it often happens that workers try to apply for those benefits anyway, which triggers the scrutiny that can result in hefty fines.”
One immediate advantage to hiring employees is that business owners can deduct payroll as a legitimate business expense.
“If they’re paying cash under the table, it never shows up and they may be showing more taxable profit than they really have,” says Henn.
Then the snowball effect can happen. Often business owners will use cash income to pay workers, so the cash income isn’t getting reported either, which usually means financial management reports aren’t accurate.
“What I tell people is that they can’t manage what they don’t see, so it really undermines any attempt at responsible financial management,” says Henn. “Plus, if they ever want to sell the business, it won’t show an accurate picture.”
Fred Going, a shareholder of Worthing and Going PA, says, “Establishing a true payroll labor cost provides you with the knowledge on how to properly charge for your product or time. This information is critical for the long-term success of your business.”
Beyond that, paying employees “under the table” is against the law.
“By conducting yourself ethically, you can focus on how to build a successful and profitable business versus wondering when someone will spill the beans,” Going said.
Nancy Strojny, chairwoman of the Portland Chapter of SCORE, says entrepreneurs have a responsibility to their employees and their community to pay the costs of hiring.
“An audit can destroy the savings and good will the small business has built overnight,” Strojny said.
So whether you’ve hired an independent contractor or an employee, there are great benefits to doing things above board.
“It is a peaceful night’s sleep knowing you have protected yourself and done the right thing,” says Strojny, “and that’s a decision you can live with.”