As we all know well, Independent contractors (ICs) must pay their own state and federal income taxes, and with employees an employer has to collect federal taxes and pay part of the Social Security and Medicare taxes. As a result, a number of business owners prefer to hire Independent Contractors. However, there exists a fine line between ICs and Employees and  there are a number of factors to consider to determine when determineing whether the person you have hired is an Independent Contractor or a disguised Employee.

After you have made the decision to converting an IC to an employee there are a number of formalities that need to be completed including, but not limited to, formally hiring the IC as an employee and placing them on a payroll. Several changes occur to the type of federal tax forms you issue to the worker, deductions you will need to make from their paychecks, and employment rules. In case you come across this phrase in the materials listed below, the IRS refers to this conversion process as “voluntary reclassification.”

When to begin the Conversion Process:

(1) During the current tax year. If reclassification is effective immediately, then for the 2010 tax period you will issue to your workers both a 1099-MISC and W-2 form.

(2) The beginning of the next tax year. If you keep workers as ICs until January 1, 2011 and then treat them as employees, only a 1099-MISC form is required for this year and W-2s will be used after that.

There is one little caveat with changing employment status. Due to ongoing legislation, the IRS has become stricter with the use of ICs and what employment relationship qualifies for IC status. Consequently, the IRS may audit an employer who reclassifies an employee as an IC to determine if there has been a significant change in the employment relationship to justify the reclassification.

However, that being said, a voluntary reclassification from IC-to-employee is less likely to come under scrutiny. To underscore this shift in your employment relationship with your workers, I suggest giving them formal offers of employment that outline their added responsibilities, work polices, etc., and maintain a copy of the letters along with their basic information. If you are converting several IC’s you may also consider putting together employment agreements and handbooks.

Below is a list of Federal and Washington State procedures and applications that must addressed before the conversion process is complete.

Federal and State procedures

Federal Procedures

• Apply for a Federal Employer Identification Number from the IRS unless you already have one. It is also referred to as the Employer Tax ID or SS-4 Form. To contact the IRS directly for the EIN, the number is 1-800-829-4933. Apply for an EIN Online along with instructions

• Complete the Employee Eligibility Verification I-9 form within three days of hiring your first employee. The form is not filed, instead an employer must maintain it as part of the worker’s records for 3 years after the date of hire or up to 1-year after termination of employment, whichever is later. Download Instructions and I-9 Form Employment Eligibility Verification

• Have your new employees fill out and W-4 forms. This is for you to keep in their files and helps determine how much you will need to withhold for Federal Income Tax. Download W-4 Form Employee’s Withholding Allowance Certificate

• Collect Federal Withheld Income tax, Social Security tax, and Medicare tax. Using W-4 to determine withholding amount

• Pay half of the OASDI contribution under Social Security (Old-age, Survivors, and Disability Insurance). For 2010, this is 6.2% of wages paid up to annual wage base of $106,800. The employee’s share is also 6.2%.

• Pay part hospital insurance contribution (Medicare). For 2010, this is 1.45% of all wages paid. The employee’s share is also 1.45%.

• Issue W-2 forms at the end of tax period when employee status is effectively begins. W-2.

• Send a copy of workers’ W-2 forms along with W-3 forms to the Social Security Administration. For employer filing and more information

• File either Employer’s Quarterly Tax Return 941 Form, or Employer’s Annual Federal Tax Return 944 Form. Originally, small business with an annual income tax liability of $1000 or less were required to file the 944 Form. As of January 1, 2010, businesses may contact the IRS opt in or opt out of filing the 944. Reporting Federal Tax Return 941 Form.
  

• File Employer’s Annual Federal Unemployment Tax Return (FUTA) if wages paid were $1500 or more for any quarter or one or more employees worked for you for at least 20 weeks out of the year. This comes from your own funds; employees’ wages are not withheld and used towards this. Reporting FUTA taxes and Instructions

WASHINGTON STATE PROCEDURES

• Re-file your Master Business Application to indicate employee-hiring status. This will also register and open accounts for worker’s compensation with the Department of Labor and Industries and unemployment insurance with the Employment Security Department. Hiring Employees and Registering with Washington State
• Report newly hired and re-hired employees to the state’s directory within 20-days. New Hire Reporting Program. You will need to enter your Federal EIN.
• Obtain Worker’s Compensation Insurance either through a private insurer, Washington’s Worker’s Compensation Insurance program, or as self-insured. Also, file quarterly workers’ hour and compensation reports. Worker’s Compensation and More Information Here
• File and Pay Unemployment Insurance Tax Here.
• Meet minimum wage and hour requirements. Link to Washington State’s policies
• Post required workplace labor posters State and Federal

EMPLOYMENT RECORDS TO MAINTAIN

• Records of Employment Taxes for at least 4 years. 
• Copy of W-2s. Employee’s Withholding Allowance Certificate W-4 Form
• Mandatory recordkeeping procedures for Washington State. Record Keeping and Access to Payroll Records

ADDITIONAL RESOURCES

• Outline of steps necessary for hiring employees with explanation on what each step means. Employee Hiring Steps
• Process for paying employee’s withheld contributions and employer’s contributions. Federal Tax Deposits
• This is the IRS’ Employer’s Tax Guide that reviews federal tax filing requirements. Employer’s Tax Guide and Employer’s Supplemental Tax Guide
• Links and IRS information for Employment Taxes. Employment Taxes
• Payroll outsourcing information. IRS guidelines.
• IRS Employer Forms and Instructions
• For assistance on meeting federal payroll requirements such as withholding income tax and Social Security, the IRS has a Business and Specialty Tax line at 1-800-829-4933.

For questions on determining whether to convert your IC into an Employee as well as help completing the procedures please feel free to contact us.