Succeeding in Your Business by Cliff Ennico

"My husband and I have a small business, and there are several people who work with us on a fixed schedule. We are the only company they work with. From previous columns you've written, it's clear that if we are someone's only client and he works almost 1,500 to 1,800 hours for us every year, we should convert them to 'employee' or W-2 status, and start withholding and paying employment taxes. The problem is . . . these people don't want to become employees, because as independent contractors they get to take business expenses as tax write-offs.

"These days I'm hearing a lot about so-called 'W2-Contractors.' As I understand it, these people are still basically independent contractors who get paid depending on the number of hours that they work multiplied by their hourly rate, but the company withholds and pays all federal and state income and employment taxes on their income. They get a W-2 at the end of the year, not a 1099, but they don't get any benefits in the company. Is that a better or less risky way to go than treating them as independent contractors for tax purposes?"

There are few more difficult decisions for a small business owner than determining whether someone who works regularly for you part time is an "employee" or "independent contractor" for tax and legal purposes. Generally, someone cannot be both an independent contractor (or "1099," because that's the IRS form you send contractors at the end of the year) and an employee (or "W-2," because that's the IRS form you send employees at the end of the year) at the same time.

The IRS complicates matters by allowing you — on a strictly voluntary basis — to withhold from an independent contractor's paycheck all federal and state income and employment (FICA, FUTA and Medicare) taxes. A number of small businesses have viewed this as a "loophole" in the tax laws allowing them to treat their contractors as "employees" for tax purposes and "contractors" for all other purposes. Hence the name "W2-Contractor" to describe such folks.

But . . . by doing so you don't avoid having to make the fundamental decision of whether a person is your employee or independent contractor. Even if you withhold taxes from a contractor's paycheck, you are still required to treat him or her as a contractor and send out Form 1099 at the end of the year, not Form W-2.

"Wait a minute!," I can hear some of you saying. "If you're withholding taxes from their paychecks, then the government is getting their tax money on time, and in the right amounts.

There's no risk that the contractor will play games on their taxes, or fail to make quarterly estimated payments of taxes. Isn't this a case of 'no harm, no foul' where everybody, including the IRS, benefits?"

The short answer is . . . maybe.

Here are two problems with the "W2-Contractor" arrangement that I can think of (there probably are more):

(1) If you and your husband have any sort of pension or retirement plan (such as a 401K plan) for your small business, giving your contractors W-2 forms at the end of the year but not allowing them to participate in your plan may violate the prohibition against discriminatory or "top heavy" plans in the federal Employee Retirement Income Security Act of 1974 ("ERISA"). I'm not an ERISA lawyer and cannot tell you for certain if a "W2-Contractor" arrangement will put your plan in jeopardy, but you should check with one before putting this arrangement in place.

(2) Under the labor laws of many states, you are required to provide a certain minimum level of benefits to your employees that contractors don't qualify for. For example:

— in most states you are required to provide worker's compensation insurance coverage for employees;

— in many states you are required to make payments to a state unemployment insurance fund for employees;

— in a few states you are required to give your employees X days of paid sick or medical emergency leave;

— in California, you may prohibit an independent contractor from working for a competitor after the contract relationship is ended, but you cannot prohibit an ex-employee from working for a competitor.

Even though a "W2-Contractor" arrangement may technically comply with the IRS rules governing employment taxes, there are lots of other rules out there that require you to distinguish between employees and independent contractors. You will have to speak to an employment or labor attorney in your state to get the full picture.

"W2-Contractor" is a contradiction in terms. Even if you are satisfied that your state does not absolutely prohibit treating your people this way, I wouldn't want to be in your shoes if a disgruntled ex-"contractor" complains that you did not give him required benefits and your state attorney general's office wants to bring a "test case" against your business. Just imagine all the unwanted publicity in your local newspapers . . .

Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

COPYRIGHT 2008 CLIFFORD R. ENNICO.

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