Tempted to pay contractors in cash? Consider the serious tax penalties

Many sub contractors in the construction fields rely on a network of friends and acquaintances when work starts to roll in during the busy season. Asking a cousin to help on one project and paying in cash may seem easier than cutting a check or determining whether he might qualify as an employee. But, if the Internal Revenue Service audits your company and discovers the cash payments it could mean paying back employment taxes, accrued interest and a civil penalty.

An IRS investigation in Pennsylvania provides a good example. Tax charges allege that three men ran businesses that paid employees in cash from 2006 to 2012 amounting to $7 million without proper withholdings.

Employers need to withhold federal and state taxes based on the number of allowances an employee lists on Form W-4. In addition, the Federal Insurance Contribution Act (FICA) requires withholding certain percentages for Social Security and Medicare. The employer pays these trust fund payments to the IRS on behalf of the employee.

On the tax evasion and conspiracy charges, the Pennsylvania men face penalties of up to $250,000 in fines and five years in prison. The false tax return charges carry a similar fine and up to three years behind bars. This does not even include the back taxes owed as restitution.

The next issue that often flows from the scenario of having someone work for you on an occasional basis is whether they ought to be classified as an employee or independent contractor.

Amount of control over work an important factor

The misclassification of employees as independent contractors is also common as businesses look to reduce overhead and payroll expenses. A company does not need to withhold taxes or offer benefits to independent contractors.

Lowe's recently reached a settlement of approximately $6.5 million with workers it had misclassified as contractors. The contractors who did installation for the home improvement giant alleged that they were in fact employees. Lowe's made installers tell customers they worked for Lowe's, In addition, they had to attend Lowe's training and wear company branded hats and shirts at various jobs. The level of control exercised was more akin to that of an employer and employee.

The IRS provides three common law rules on its website. These include:

  • Behavioral control - Who is in charge of deciding how and when to complete a project? A contractor is more likely to bring his or her own tools, pay for necessary licenses and work comp insurance.
  • Pay arrangements - Does the worker stand to lose money? Has he or she submitted a bid? A contract that stipulates the timing of payments may indicate a contractor relationship.
  • Type of relationship - How long will the relationship continue and are benefits available? Access to a retirement savings plan may indicate more of an employee relationship.

It is often difficult to distinguish between an independent contractor and employee. The IRS offers opinions through its Form SS-8. After submitting the request, the agency reviews the employment circumstances to determine worker status.

The IRS also offers a program called the Voluntary Classification Settlement Program for taxpayers who have misclassified workers. It allows an employer to reclassify workers and receive partial relief from past employment taxes owed.

The penalties for paying in cash or misclassifying workers are extremely serious. When you receive notice of an IRS audit or want advice when hiring new workers, an experienced tax attorney can provide individualized guidance.

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