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How to Properly Classify Employees and Contractors for Bookkeeping Purposes


As the business world evolves to keep pace with changing technology, bookkeeping grows more complex and there are more questions accountants may have to answer for their clients.

One example of this is the growth of telecommuting and part-time positions. Smart business owners are discovering that a full-time, in-house employee is not always the best solution for every position in the company. The prevalence of businesses using independent contractors for a variety of business functions leads to questions classifying employees for tax purposes.

What’s more, misclassification of employees is a big red flag for the IRS. Misclassifying employees can lead to a small business tax audit – a scenario no business owner wants to face. Independent contractors are often called “1099 employees,” but this wording is actually misleading. An independent contractor is not an employee at all.

Let’s review how the IRS classifies employees and contractors for tax purposes.

Defining an Employee

The IRS uses 20 different factors for classifying an employee v. an independent contractor. In today’s age of telecommuting, the location where an employee works is less important than “how” an employee works.

In the simplest terms, if the employer controls what will be done and how it will be done, the worker is an employee.

When an employer deals with an independent contractor, the payer can control or direct the end result of the work, but not the means by which it’s completed. As long as the contractor doesn’t violate any contracts, such as non-disclosure agreements, they can go about any means they prefer to achieve the results the client wants.

For employees, the employer may direct the hours worked, the processes and procedures used, and the preferred location for work.

“One of the Biggest IRS Red Flags”

Misclassifying employees as independent contractors is a big red flag for a business owner to be audited. And the mistake is made months, or even years, before tax filing takes place.

When your virtual accounting department comes onboard to assist with your payroll, we can help you classify employees properly. Employers must pay unemployment benefits, social security taxes and, in this new age of the Affordable Care Act, may also be mandated to provide insurance benefits to employees.

An accounting consulting or financial controller, part of your team, can help you classify employees properly so you don’t have any surprises at tax time. Many companies call because they are looking for daily or weekly bookkeeping services. But they discover the range of services we provide goes far beyond just balancing your books, and can really help business owners run a tighter ship in every way.

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