A small business can save a good deal of money by not having employees. According to the U.S. Department of Commerce, it costs businesses 20-40% more per worker to classify someone as an employee versus an independent contractor. Although calling someone an independent contractor can save a businesses a lot of time and money, the consequences of re-classification by the IRS can be severe if the person is actually acting in the capacity of an employee.

Classifying individuals as non-employees is tricky. It is very risky to directly engage individual contractors who do not have a business license, a state business identification number, their own place of business, their own equipment, and who are solely dependent upon your business for their livelihood.

Hallmarks of an Independent Contractor
Bona fide independent contractors meet the following criteria, among others:

1. They are in business for themselves;
2. They typically have multiple clients;
3. They determine whether they will do the work themselves and/or use employees or subcontractors;
4. They furnish their own tools, equipment and materials; and
5. They pay income and business taxes on business revenues and payroll taxes on employee compensation.

In short, independent contractors should not be working full time at your business, using your equipment and supplies and doing the same work as your employees.

The Risk
The IRS can order offenders to pay all employment taxes that should have been paid plus a penalty that ranges from 12-35% of the tax bill. And that’s just the federal side of the equation. Your state will likely weigh in and take a bite out of you for back state payroll taxes and fees, plus their own penalty for non-compliance.

The Tip
If you are using independent contractors to assist with your business, make sure you are treating them as contractors and not employees. A few things you should do to protect the classification are:

1. Pay them by the job, not the hour;
2. Don’t require all work to be done on your premises;
3. Make sure they have their own business licenses;
4. Have all contractors sign a contract detailing the terms of the relationship.

Contractors come in all shapes and sizes; the ones you hire directly should be bona fide contractors with established business credentials to avoid the risk of re-classification by the IRS.

A very important part of the organizational documents that is regularly overlooked by business owners are the buy/sell provisions. For most closely held businesses, the buy/sell provisions among the co-owners define how and when individual owners will ultimately realize a return on their investment in the venture. Although many owners are initially confused by the need to give significant attention to provisions dealing with exit scenarios during the early planning stages of the business, the confusion usually disappears very quickly as the owners begin to realize that these provisions define what they may ultimately get in return for all of their invested capital and effort.

Business owners need to prepare early for the day when they will part company for whatever reason. At some point down the road, every entrepreneur is going to have to, or want to, cash out or transfer his or her equity interest in the business. Someone is going to leave the business, die, become disabled, or experience a messy divorce.

Potential separation issues are just one very important part of the initial planning and documentation process that should be addressed in a calm, planning-oriented atmosphere and not at a point of crisis. Taking the effort to address these types of issues at the outset is also the most logical time to do so, when the business organizers are making other important decisions about their devotion of capital and energy to the business enterprise. Thinking and discussing key issues upfront often will bring to the surface the different expectations of the owners. It helps to have these expectations out in the open before irrevocable commitments are made to the business.

Choosing the right type of business entity for your new company is a critical decision that will have long-range effects on management authority, liability protection, taxation and transferability. Each type of entity has its own advantages and disadvantages, so make sure to take the appropriate time and seek advice to empower you to make an informed decision.

Below is a general overview of several entity types and the implications on some important business factors. Click on the graphic to download a PDF version of the file.

Before you hire the first employee for your business, make sure you understand the gauntlet of government regulations and administrative requirements you will face.

There are many, many requirements that need to be taken care of, but here is a list of some basic legal and administrative obligations:

1. Obtain an employer identification number (EIN).
   This is similar to a Social Security Number for a business and will allow you to submit documents to the IRS. An EIN can be obtained by filing IRS Form SS-4, which can be downloaded on the IRS website.
2. Get worker’s compensation insurance.
   In many states employers are required to buy worker’s compensation insurance, which protects them from lawsuits resulting from work-related accidents. Though it is highly recommended, you should investigate your state regulations to determine if it is required.
3. Have employees fill out Form W-4.
   Form W-4, which is the Withholding Allowance Certificate, allows employees to claim a certain number of allowances for tax purposes, and helps employers withhold the correct amount from the employees’ paychecks. If employees wish to change the number of allowances they claim, they’ll need to fill out a new form with their employer.
4. Fill out Form I-9.
   U.S. Citizenship and Immigration Services requires employers to fill out Form I-9, which is the Employment Eligibility Verification form, for each new hire. This form is used to verify that your new employees are eligible to work in the United States. This form does not need to be filed with the USCIS, but does need to be kept on file for three years and must be provided upon inspection by the USCIS.
5. Report new hires to your state’s new hire reporting agency.
   The Administration for Children and Families, part of the U.S. Department of Health and Human Services, requires that employers report all new employees to their state’s new hire reporting agency. The information is used to locate parents who owe child support.
6. Determine what OSHA regulations apply.
   All employers (with few exceptions) need to comply with the requirements of the Occupational Safety and Health Act. You can check out the OSHA website to review the rules.
7. Withhold taxes.
   Set up a payroll system so that income taxes, Social Security, and Medicare taxes are automatically withheld.
8. Deposit taxes.
   Taxes, Social Security, and Medicare paid by the employee, along with the company’s portion of the Social Security and Medicare taxes, must be handed over to the government on a periodic basis. You can do this a few different ways.
   a. Larger employers deposit through the Electronic Federal Tax Payment System;
   b. You can mail or deliver these taxes to a Federal Reserve Bank or authorized financial institution;
   c. If quarterly withholdings are less that $1,000, you can pay them through your quarterly tax return (Form 941);
9. File Form 940 annually.
   The Employer’s Annual Federal Unemployment Tax Return (Form 940) can be obtained on the IRS website.
10. File Form 941 quarterly.
    The Employer’s Quarterly Federal Tax Return (Form 941) can be filed via mail, or if you’re eligible, it can be filed using the 941TeleFile system.

Question:
I am considering creating an LLC for my business but don’t understand how it and I would be taxed. Will you explain?

Answer:
With a Limited Liability Company (LLC), you have a tremendous amount of flexibility on how the entity is taxed. If the LLC has a single member, the default is for it to be considered a disregarded entity and for the LLC’s income and expenses to become the income and expenses of the LLC member. If the LLC member is an individual, the LLC’s income and expenses would be reported on Schedule C of the member’s Form 1040.

If the LLC has multiple members, the default is for it to be treated as a partnership. As a result, the LLC would have to file a Form 1065 annually and to issue each member a Form K-1 (Form 1065), which would list each member’s share of the LLC’s income and expenses. Each member would then be required to report his or her respective share of the LLC’s income on the member’s tax return.

An LLC can also ELECT to be treated as an S corporation. This requires filing Form 2553 with the IRS by the applicable deadline. If the LLC is treated as an S corporation, the S corporation would file Form 1120-S with the IRS and issue each LLC member a Form K-1 (Form 1120-S). Each member would then be required to report his or her respective share of the LLC’s income on the member’s tax return. The LLC may also issue a Form W-2 to the member of the member is an employee of the LLC.

An LLC can also ELECT to be treated as a C corporation. This requires filing Form 8832 with the IRS by the applicable deadline. In this case, the LLC would file Form 1120 with the IRS and would be taxed on all of its taxable income. The LLC would issue a Form 1099-DIV for dividends paid to LLC members (which would get reported on the members’ tax forms) and a Form W-2 if the member is an LLC employee.

The question of how you want your LLC to be taxed can be a complicated one. If you have any other questions, please let us know.