Employees or Independent Contractors?

In an earlier post about IRS wage reporting requirements, we talked about the different requirements for your business’ employees and/or independent contractors.  In that post, we promised that we’d explore the differences between the two classifications.  Today, we’re making good on our word.

Your business may hire both employees and independent contractors.  You pay both classifications of workers and, in turn, both classifications provide you with labor.  So, who cares what you call them?  Well, your Uncle Sam cares.  For your employees, you almost always have to withhold income, Social Security and Medicare taxes, not to mention paying unemployment benefits.  For independent contractors, you don’t have to withhold any of those taxes.

So, why not just call everyone an independent contractor and forget about all the payroll headaches associated with withholding?  There are, of course, serious penalties for incorrect classifications.  If you classify a worker as an independent contractor and the IRS determines that the worker should have been classified as an employee, you will have to pay the government all of the taxes you should have withheld and, as a kicker, you have no right to recover those costs from the worker – effectively meaning you would have paid that worker’s taxes twice.  And that’s just if you make a mistake – if the IRS determines that you intentionally misclassified the worker, you will owe the government double what you should have paid (and you still can’t collect anything back from the worker, meaning you will have paid that worker’s tax liability three times).

Now that you know you don’t want to classify a worker incorrectly, either innocently or on purpose, how are you tell the difference?  Sadly, this is the hard part.  In 2001, the Rhode Island Supreme Court said: “the test as to whether a person is an independent contractor is based on the employer’s right or power to exercise control over the method and means of performing the work.”  If that sounds fuzzy to you, that’s because it is.  There is no hard and fast rule, except that your preferred label does not matter – just because you and a worker sign an independent contractor agreement does not make that worker an independent contractor.

What matters is how the relationship works in practice.  The IRS published an article with some helpful guidelines.  Three aspects of the employer’s “control” are examined:

1. Behavioral control:  Does the employer instruct the worker to perform the work in a particular place or at a particular time?  Does the employer dictate the sequence of work?  Does the employer evaluate the worker based on the work process or just the result?  Does the employer provide training?
2. Financial control: Does the employer or the worker pay for the worker’s business expenses?  Is the worker free to market services to other potential employers?
3. Relationship control: Is the worker expected to perform a discrete task or to perform tasks as needed?  Is the worker expected to work for a specific period of time, or is the hiring open-ended?  Is the worker entitled to receive benefits from the employer?

This is not an exhaustive list of factors, and no one factor is determinative of the outcome.  To classify workers correctly, it’s important for businesses to assess the entire working relationship in light of the concept of control.  The more control the employer exerts over the worker, the more likely it is that the worker will be considered an employee, subject to withholding.

To the extent you’re still not sure (and who could blame you), you can file IRS Form SS-8 to seek a binding determination from the government, or seek the advice of an attorney.

The Next Shot in the Estate Tax Battle

As we’ve discussed previously, right now there is no estate tax.  As a result of a prior tax deal, the estate tax was phased out as of January 1, 2010 and is scheduled to return on January 1, 2011 with an exemption amount of $1 million per individual and a top tax rate of 55%.  Most folks assume, however, that the estate tax will be reintroduced in some form before then, with different exemption amounts and rates.

President Obama released his budget earlier this week and, no surprise here, he seeks to reinstate the estate tax at 2009 levels.  This would mean individual exemption amounts of $3.5 million and a top rate of 45%.  Yesterday, CNN reported that the Senate is considering a different, and more generous proposal, which would grant exemption amounts of $5 million per individual and a top rate of 35%.  Both Treasury Secretary Timothy Geithner and Senate Finance Committee Chairman Max Baucus indicated yesterday that they support making the estate tax, in whatever form it finally materializes, retroactive to January 1, 2010. (thanks to TaxProf Blog for linking to the Geithner and Baucus statements).  We will keep you updated as the debate continues.

No Net Receipts Tax

A while back, we wrote about Governor Carcieri’s decision to float the idea of a net receipts tax as a “game changer” for Rhode Island’s current tax system.  Essentially, the plan would have imposed a 2% tax on all businesses’ net receipts.  The income theoretically would have been able to replace the corporate and personal income taxes.

The Providence Journal reported today that the governor has abandoned the idea.  Speaking on Buddy Cianci’s radio show this afternoon (we’re relying on the Projo report here; we didn’t catch the radio interview), Carcieri said “It’s just too complicated right now.”  While we don’t really know enough about the tax’s proposed structure to have an opinion whether or not it’s a good idea, we certainly were encouraged to think that the administration was searching for alternative ways to raise revenue.  And today we’re equally discouraged that after only two months – with no public debate of the plan that we’re aware of – it’s dead.

Can Your Business Get Into Politics?

On Thursday, the U.S. Supreme Court announced its decision in Citizens United v. Federal Election Commission.  This landmark holding alters the roles that corporations play in our nation’s political discourse.  Before the ruling, federal (and most state) law prevented corporations from making political donations or expenditures.  But not anymore – after Citizens United, the landscape is very, very different.

The Supreme Court held that the First Amendment bars the federal government (and, probably state governments, too) from passing laws that prohibit corporations from engaging in political speech through independent expenditures.  There are two important elements to the ruling.  First, political speech is not just the spoken word – it includes writings and other modes of communication.  Second, independent expenditures are those that advocate the election or defeat of a candidate for public office but are not coordinated or discussed with any candidate or candidate’s opponent.  For example, if a corporation wants to support a candidate for election, that corporation may now create and distribute a flier in support of that candidate (but can’t talk to the candidate or her/his campaign manager to make sure the flier is ok).

Equally important are the portions of the law that the Supreme Court left standing.  First, corporations still may not donate money directly to a candidate or a candidate committee – the potential for bribery is just too great.  Second, when corporations make these independent expenditures, the existing disclosure and reporting laws still apply.  So, in our earlier example, the corporation would have to state, somewhere on the flier, that it paid for the flier (and there are actually pretty picky rules about where the notice must be placed, how big it must be, etc.).  And, second, the corporation would have to file a report with the Federal Election Commission stating that it had created the flier (and a host of other information).

Reaction has been typically hyperbolic.  Some political liberals are screaming that this decision will lead to big businesses spending as much as they can to buy elections – while some political conservatives are just as concerned that the ruling will open the floodgates for unions to do the same thing.  The plain fact is that, even before Citizens United, big businesses and unions already exercised immense influence in politics and elections.  Anyone watching the legislative circus that has been this year’s attempt at health care reform has seen with their own eyes the power and effect that these interest groups have on the process.  Big business and unions already spend millions and millions of dollars on elections – it’s just that pre-Citizens United, they had to wash it through PAC’s and lobbyists.  But for us, the outrage is a little overblown.  Just because business and/or unions can now spend their money directly does not mean that: 1) they will spend more money (they can already spend all they want, assuming they properly wash it first); or 2) that the same amount of spending will somehow become more effective.

We think the ruling will be important, but in a local way.  When we read the decision, we thought about a client.  A small business in the retail sector, this client had a very difficult time receiving proper permits and licenses, in good part because of the intransigence of a certain local elected official (all of whom shall remain nameless).  It was so bad, they had to call us to straighten out the mess.  At the end of the affair – when the permits finally were issued – the client’s president, angry at the way the official had acted, wanted to know how to fight back.  In the aftermath of Citizens United, that owner has another option.

Do You Have a Smartphone App?

They’re so cool – and they’re only going to get hotter (can something be cool and get hotter?  We think so).  Smartphone apps are all the rage.  All the big names have apps for the iPhone and the Droid – CNN, Whole Foods, DirecTV and the ubiquitous Facebook are just a few of the thousands of people and businesses that have created apps so their users can stay connected while on the go.  Even Shakespeare has an app (all of the Bard’s plays smell as sweet in digital format).

Does your business have an app?  Don’t be fooled into thinking that you need an expansive outlay of cash or time to get the ball rolling.  iSites claims to be able to have your mobile app up and running in ten minutes (thanks to Fred Abramson’s New York Small Business Law for bringing this to our attention).  It costs a whopping $25 for the basic app, or a hair under $100 per year to integrate your app with other advertising programs.

We don’t know anything about the iSites product (other than what iSites claims), but for that amount of time and money, it seems like it’s worth a shot – even an app development class from Apple costs between $100-300.  Considering users downloaded 10 million apps in one weekend and the number of users and number of apps is expected to grow, maybe it’s time for you to get in on this party.

Estate Planning Advice from the NY Times

In today’s New York Times, the Gray Lady herself published an article called “A Bizarre Year for the Estate Tax Will Require Extra Planning.” In it, the author discusses what we’ve written about previously – that the estate tax is currently dead but certainly not buried (we also wrote about it here and here).  Not to rehash our prior posts, but the current estate tax is gone, Congress intends to re-enact it – in some form – and probably will make the new legislation retroactive to January 1, 2010.

An interesting thread in the piece, that we haven’t written about, is the interplay between the estate tax and the capital gains tax.  Previously, the estate tax scheme valued property at the time of he owner’s death and did not calculate any gain on the value of an asset.  But, with the estate tax out of commission, the capital gains tax steps in to fill the void.  So, let’s say someone bought a house in 1975 and died this week, leaving the house to two children.  If the children sell the house, they will be responsible for paying tax on the appreciation in the house’s value from 1975 to 2010.  Ouch (there is an emergency IRS ruling that grants a small capital gains exemption on some property, and a larger exemption for surviving spouses, which should ease some of the pain).  And that, sadly, is the easy part.  Assume that instead of a house, that same person spent $10,000 in 1975 on stocks.  What price per share did s/he pay (unlike houses, there are no public records of every stock share transaction)?  Have the shares split?  Was the company bought?  Does the broker who sold the stock still exist?  Headaches galore…

Not only will the capital gains tax affect some heirs significantly, it will affect many more heirs than the estate tax would have.  Early estimates assume that about 70,000 people will be hit by the new capital gains tax requirements.  About 5,500 would have been affected by the estate tax at 2009 rate and exemption levels.  Are you one of those people?  As the articles goes on to say, the best way to figure out what this all means is to sit down with your financial advisor and estate planning attorney and make sure that your estate plan still fulfills your needs.  We couldn’t have said it any better ourselves.

Rhode Island Probate Process

In response to a recent post about estate taxes, a reader sent in a request that we explore some of the potential pitfalls of the probate process.  It’s a great question, and a topic that we plan to address in detail.  But, we thought it better to outline the general probate process so that everyone has a frame of reference for future discussions of discrete issues.

“Probate,” generally, refers to the court supervised process for organizing, collecting and distributing the property of a deceased individual.  Importantly, not every deceased person’s affairs must be resolved via probate – there are methods to avoid probate that we will review in future posts.  But, to the extent that a person dies owning property that is not automatically transferred by other means (such as a trust, or beneficiary designation on a life insurance policy), then that property will pass through probate.

The first step is a trip to the probate court in the city or town where the deceased person lived (for this post, we’ll call the deceased person Smith).  The Secretary of State maintains a current list of probate court contact information.  The purpose of the trip is to designate Smith’s personal representative.  If Smith had a will, it usually designates an executor.  If Smith did not have a will, or the individuals nominated by Smith are unable or unwilling to serve as executor, the court will appoint an administrator.

It is the personal representative’s job (let’s call the personal representative Jones) to complete the probate process, subject to supervision by the appropriate probate court.  Jones may be aided by an attorney, an accountant and sometimes other professionals.  Which can be very helpful, because Jones has a lot of work to do.  First, Jones must send a notice to all of Smith’s potential beneficiaries and take possession of all of Smith’s property and prepare a thorough inventory.  Then, Jones must collect any money due to Smith (for example, if Smith owned income property, Jones would have to make sure the tenants continued to pay rent to Smith’s estate until the property is transferred).  Jones must determine Smith’s outstanding debts and pay them from the assets of Smith’s estate.  Jones has to prepare, file and pay state and federal estate taxes .  Finally, assuming there is some money left over in the estate after payment of all debts, Jones must distribute those assets according to the terms of the will or, if there is no will, according to Rhode Island laws of intestate succession.  Finally, Jones must secure the probate court’s approval of all of the above.

There are a few important deadlines as well.  First, the state and federal estate taxes must be filed within nine months of the date of Smith’s death.  Second, the estate must remain “open” to the probate process for at least six months.  The law guarantees at least that much time for Smith’s creditors to file claims with the estate.  As a practical matter, however, the probate process can take a lot longer.  There are a lot of reasons why this may be the case, but the real killer is litigation.  Probate litigation arises from many causes, they are all expensive and some, like family disputes over who was supposed to inherit a particular piece of property, can be very nasty (in 2003, the R.I. Supreme Court awarded more than $16,000 in legal fees to a woman who had a $28,000 dispute with her sister over their mother’s estate).  They are to be avoided whenever possible.

There are some good resources that can help.  In addition to the contact information above, the Secretary of State maintains an online library of probate forms.  Also, the Rhode Island Bar Association’s website contains a brief overview of the probate process.  And, of course, you are always free to contact an attorney with your questions.

Detecting and Preventing Fraud

A client came to me with a problem that is a good cautionary tale for all business owners out there.  She was the owner of a small business with 10-15 employees (the exact number varied over the years).  The business’ office manager was an old friend and had worked for the owner for almost a decade.  The office manager did almost all of the back office paperwork – he invoiced clients, paid suppliers, ran payroll and handled the bank paperwork.  He took a day off to take his child to visit college.  That day, the owner took a call from a supplier (since the manager was away) and the supplier said that the business had sent them a check for the prior month’s invoice intended for another supplier.  The owner apologized and promised to reissue a check that day.  She called the supplier who was supposed to get the wrongly mailed check and, sure enough, that supplier also got the wrong check – the two envelopes somehow had been switched.  Wanting to be thorough (and to maintain good relationships with her suppliers), she began to call other suppliers on that month’s check run to make sure they got the right payment.

All the other checks were fine, except she found a vendor whose name she did not recognize.  She went to the manager’s office and found the vendor’s file.  The phone number on the invoice was inoperative and no address was listed.  The vendor had no website or e-mail and the owner could not find any mention of it on the internet.  For almost four years, the business had been sending this vendor $850 every month for “technical support” services.  By this point, the pit in her stomach told her what had happened and she went back through copies of old bank checks to confirm it.  The manager had created a dummy company and was sending fake invoices to the business every month.  The manager created an alias in the company’s accounting software so that he could issue checks to himself and the software would report that the check was issued to the fictional vendor (the manager knew that neither the owner nor the owner’s accountant reviewed copies of the actual checks; all reviews and audits were done off the accounting software printouts).  All told, the manager took the company for a hair less than $40,000.  The manager had blown most of the money on vacations and expensive restaurants – meaning there was a very slim chance that the business would be able to gets its money back.

Sadly, this is not an isolated incident.  The Association of Certified Fraud Examiners estimates that fraud impacts small businesses harder than larger enterprises – the average fraud loss is higher and fraud rates are more common.  And, in light of current economic conditions, more than 50% of small businesses are reporting an increase in fraud over the last 12 months, with half of that number claiming increased financial pressures as the cause of the fraud (thanks to Small Business Trends for these numbers)

This kind of internal fraud usually is a result of the small business’ lack of internal controls.  Both the ACFE and the National Federation of Independent Business offer some guidance on how to keep your business clear of fraud:

1. Hiring and Retention: It’s nice that you can give a job to an old friend, but that doesn’t mean you should.  And, under no circumstances, should you refrain from employee oversight.  It is your business, it is your money and it is your job to make sure that your employees are doing what they’re supposed to be doing.

2. Divide Responsibilities: Unless it’s you, no one individual should have access to all of your financial transactions.  Split the responsibilities for incoming and outgoing money, at the very least.

3. Audit, Audit, Audit: Sure, someone does your taxes every year.  But, you should audit your books more frequently.  Some accountants recommend quarterly audits, others recommend multiple audits each year at random intervals.  Make someone besides the person who writes the checks look at the checks and reconcile them to the bank statements and accounts.

4. Treat Your Employees Well: It is statistically less likely for people to commit fraud when they believe they are being treated fairly.  This includes salary, benefits, and workplace environment.  Are employees encouraged to speak their minds?  Is there a way to report misbehavior by other employees (even if reported anonymously)?  How do you act?  Do you act ethically and honestly with your employees?  If you do right by your business and your people, it is much more likely they will do right by you.

More Incentives for Energy Reduction

Back in December, we wrote about National Grid’s Small Business Energy Efficiency Program.  That post got us thinking about, and looking for, more incentives for businesses that increase their energy efficiency.  Not counting the programs offered by National Grid (of which there are six), there are ten different incentive programs available in Rhode Island (some are available only for residential use and some for business use).  A full list of those programs is available at the Database of State Incentives for Renewables & Efficiency.

One incentive that caught our eye was for solar power.  Essentially, if you install a qualifying photovoltaic solar energysystem, you can sign a contract with the Energy Consumers Alliance of New England that will pay you $.03 per kilowatt-hour of power generated.  While that doesn’t sound like much, the U.S. Department of Energy’s Energy Information Administration estimates that the average retail price of electricity for commercial buildings in Rhode Island was about $.14 per kilowatt hour as of September, 2009 (down from about $.15 in September, 2008).  That works out to about a 20% rebate of your energy costs.

And, to put the cherry on top, the contract doesn’t affect your rights under Rhode Island’s net metering law.  Net metering means, basically, that if your solar panels are generating more electricity than you’re using, your electric meter runs backwards.  If, at the end of the month, you generate more electricity than you use, you can carry the credit over to the next month.

Now, put those two plans together.  If you install a solar panel, you get paid for all the electricity that system generates.  And, you get to use the electricity, which will lower – and possibly eliminate – your monthly bill.  This kind of double dipping will help recoup the initial cost of the system much, much faster.

Businesses’ Annual January Wage Reporting to the IRS

Happy New Year!  January is an opportunity to turn the page and start fresh (and after the difficulties of last year, we’re approaching 2010 with some relief).  But, before businesses can press forward into the new year, they need to take care of some of last year’s housekeeping details, and very few are more important than their tax reporting requirements.

One of the most important reporting requirements is the preparation of workers’ wage reports.  This can be done by completing Form W-2 for employees or by completing Form 1099 for independent contractors (the IRS website contains instructions and forms for completing both the W-2 and the 1099).  We’ll cover the distinction between employees and independent contractors in a future post.  For now, if a business is unsure whether to treat a worker as an employee or independent contractor, it should contact an attorney for assistance.

Ordinarily, businesses must provide W-2 forms to employees no later than January 31.  But, since January 31, 2010 is a Sunday, the IRS has generously given an additional day – this year they are due by February 1.  Businesses also must file copies of W-2 forms with the government no later than March 1, 2010, although you can get an extension of time if you file Form 8809.  The due dates are later if the business files its forms electronically.  If a business doesn’t file its W-2 forms in time, files them with the wrong information or doesn’t file at all, it is subject to penalties for every mistaken W-2 form.  The penalties range from $15 per mistaken W-2 at the low end up to at least $100 and, quite possibly more, for an intentional disregard of the filing requirement.

The requirements for Form 1099 are largely the same.  Businesses must provide 1099 forms to contractors no later than February 1, 2010 and to the government by March 1, 2010.  Extensions likewise are available by filing Form 8809 and the due dates are extended for electronic filing.  The penalties for mistaken filings are the same.

We encourage small businesses to work closely with their attorneys and/or accountants to ensure all these documents are properly prepared and filed.