guest commentary by David Potts
David Potts is a certified public accountant with more than 25 years experience. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.
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An obstacle to small business growth beginning in 2014 is the provision of the Affordable Care Act that requires businesses with more than 50 full-time equivalent employees to provide their employees health insurance or pay a stiff penalty.
Many business owners have expressed they will be reluctant to hire that next employee which would require their business to provide health insurance to all employees, not because they are evil people, but because of the significant cost of health insurance and its impact on the company’s profit. A significant reduction in profit would mean less money is available to reinvest in the company. When less money is invested in the company, a natural consequence is a reduction in the company’s future growth rate.
And in some industries, this additional cost may mean the company can’t compete.
So what should a business do when it finds itself about to exceed 50 full time equivalent employees?
One option would be for the company to analyze the tasks required to produce its goods or services and look for opportunities to outsource these tasks. Outsourcing is not new and there are many choices available to outsource business needs. It is common for businesses to outsource accounting and bookkeeping functions, customer fulfillment and service functions, and technology needs.
A second option would be to hire people as independent contractors. It’s just not always a good option. You might even say it’s potentially a nuclear option if done haphazardly. But then again, what’s your risk tolerance level?
Here’s the issue with hiring workers as independent contractors. Just because a company pays an individual compensation for working and chooses not to withhold and pay payroll and employment taxes doesn’t make the worker an independent contractor. It would be fantastic if life were that simple. Hiring an independent contractor rather than an employee would make it less costly for an owner to establish a retirement plan with retirement benefits mostly accruing to the owners. And if it was that easy to hire an independent contractor, a company would never have to worry about reaching 50 employees.
The problem with hiring workers and treating them as independent contractors is that people within certain government agencies like the Internal Revenue Service and the Department of Labor get upset. They get upset even when the worker wants to be paid as an independent contractor. Why? Because they know deep down that these “independent contractors” are most likely employees and are paid as independent contractors to avoid the additional costs of employment taxes and employee benefits.
They also know independent contractors are less likely to pay their income tax timely, and in cases where they are not issued a 1099, many will not pay their income taxes at all. And in many cases these government agencies would be right. That is why there are penalties for misclassifying workers as independent contractors when they should be treated as employees, penalties that would make the Affordable Care Act mandate to provide your employees health insurance seem cheap.
The primary difference between an employee and an independent contractor is the business’ right to control the actions of the worker. The more control a business exerts, the more likely the worker is an employee. Determining whether a worker is an employee or an independent contractor is a nebulous task, a task that should not be done without the help of a professional. And even then the answer might not be clear and the choice might come down to a particular business owner’s risk tolerance level.
But what if you could greatly reduce the risk that a worker would be classified as an employee? (Fellow accountants, attorneys, and IRS agents – reach for your antacids.) What if you were to hire a worker, but as a condition of engagement you required this worker to incorporate or organize a limited liability company? You would then hire this person’s company rather than the individual. Would this be a sham transaction that the IRS would not recognize?
Here is an excerpt from an IRS training document dated July 15, 1996 titled Memorandum for all IRS Participants in Worker Classification Training.
“Questions sometimes arise concerning whether a worker who creates a corporation through which to perform services can be an employee of a business that engages the corporation. Provided that the corporate formalities are properly followed and at least one non-tax business purpose exists, the corporate form is generally recognized for both state law and federal law, including federal tax, purposes. (Emphasis added) Disregarding the corporate entity is generally an extraordinary remedy, applied by most courts only in cases of clear abuse. Thus, the worker will usually not be treated as an employee of the business, but as an employee of the corporation.”
If you hired a limited liability company or a corporation to provide needed services, there would not be an employee-employer relationship between your business and the service provider.
If you are a growing business, you might consider this strategy to continue your growth without exceeding the 50 full time equivalent employee benchmark of the Affordable Care Act. This continued growth should be considered a patriotic endeavor, an act to be applauded. The only people that should be upset with this tax strategy are the chronically unemployed that might be forced to leave the unemployment rolls. Employment would increase, just not at your company. (If your company continues to grow, this strategy would most likely only delay the inevitable, but deferral can be a positive result.)
One last thing: the disclaimer. I’m a CPA and have represented clients before the IRS for almost 30 years. Worker classification is a difficult issue. In that short excerpt above from the IRS training materials are a lot of other issues not seen on the surface. Although it is my opinion that the strategy in this article is valid, there is a lot of room for mistakes. Structuring a transaction in this manner would not be without risk, so it shouldn’t be done without advice from a knowledgeable CPA or a tax attorney.
This strategy will work best when the worker to be hired is a professional, exhibits intelligence, and is willing to be bothered with corporate formalities. It probably isn’t a good idea to attempt to use this strategy with illiterate migrant farmers.