The Health Care Act Tax Credit: Another Battleground in the Employee/Independent Contractor Classification War?

So what’s in a name?  Are they independent contractor or an employee?  You say, “I’ve called some employees worse things,” (and vice versa).

The independent contractor/employee classification has drawn blood from employers for decades.  It is not uncommon for an employer to be penalized by the IRS for misclassifying an employee as an independent contractor.  But what is the fuss, and what does this have to do with the 2010 small business Health Care Act tax credit?

Well, before your eyes gloss over, let me explain the independent contractor/employee battle lines. I’ll start with something that is about as exciting as untangling your paper clips: taxes.

“No, no please!” You may say. Yes, I know, we are in August, not April, why look at taxes?   Sorry, there is no way around it, so I’ll use Novocain. Then, as you slowly wake up, I’ll talk about the possible independent contractor/employee affect on the Health Care Act.

Many employers like to classify their employees as independent contractors, consultants, or freelancers.  The reason is because independent contractors are not covered by most Employment laws such as: Unlawful Employment Discrimination - Title VII ADEA, ADA, ETC., Fair Labor Standards Act--Overtime Obligations, Employee Benefits – ERISA, and Union Organizing – NLRA.  In addition, the employer saves on the employer portion of payroll taxes: FICA (social security), Medicare, FUTA (federal unemployment), and various state taxes.  As a result, the savings can be substantial, not only from these taxes, but from overtime, employee benefits, unemployment benefits, and other expenditures usually identified with employees.

In introducing Taxpayer Responsibility, Accountability, and Consistency Act in the Senate in December 09, Senator John Kerry estimated that $34.7 Billion in federal tax revenue was lost between 1996 and 2004 due to the intentional or unintentional misclassification of employees as independent contractors. Needless to say, the federal government does not like to lose revenue based on some nerdy accounting classification, and so they are coming for it.

But, before you blindfold business owners and grant their last wish, you should realize that the employee/independent contractor factors vary from state to state and from court to court.  There is no bright line text.  As a result, many cases have been decided both in favor, and against the IRS. In some cases, employers suffered substantial taxes, penalties and even jail sentences.

But up to now, this issue has had very little impact on health care.  That may all change with the 2010 Health Care Act.

As you may know, 2010 Health Care Act includes a tax credit for small businesses to help them provide, or continue to provide health care to their employees.  The Health Care Act tax credit is eligible to businesses with no more than 25 full-time equivalent employees (“FTEs”), with average full-time wages of no more than $50,000.  However, to take advantage of the full credit, the employer may not have more than 10 FTEs whose average annual salary is less than $25,000.  Lastly, the employer must pay at least 50% of the insurance premium, not to exceed the IRS ceiling that is established on a state by state (and soon, regional) basis.  The law broadcasts its preference for small businesses employing low-income employees.

The law seems cut and dry, but could become complicated as the IRS set out on its mission to redefine “employee.”  Take for example, an employer who employs 10 full time employees who earn less than $25,000.  Since the employer pays over 50% of the employees insurance premiums, it seems that the employer should be entitled to the full Health Care Act tax credit in 2010.  Two years later, the IRS performs a payroll audit and finds that the employer paid an additional 10 salespersons approximately $50,000 each and treats them as independent contractors.  To the dismay of the employer, the IRS reclassifies the ten as employees and assesses heavy payroll taxes, penalties and interest on the employer for 2010 and 2011.

The next question, however, is does this reclassification invalidate the employer’s Health Care Act tax credit, assuming the ten employees push him above the eligibility thresholds?

Or, in a similar scenario what if the federal or state labor boards, instead of the IRS, audit the employer and find him in non-conformity with the labor laws by classifying employees as independent contractors as opposed to employees?  Will that trigger a recapture of the Health Care tax credit taken on the business tax returns, along with penalties and interest?

If a small business seeks to claim the Health Care Act tax credit, its strategy should not start with calculating the hours and wages of their employees.  Instead, if the above scenarios are a real threat, then it should seek council from a tax and/or labor professional and examine any situations where independent contractors may be reclassified as employees.

Tax-exempt organizations are not immune from these apparent risks since a lesser credit is available to them against some payroll taxes. Sitting on the board of a number of tax-exempt organizations, I can imagine that a miscalculation of this Health Care Act tax credit could seriously injure a small tax-exempt organization. I have seen some make the mistake of hiring persons as independent contractors without knowing about the classification exposure.

This issue could potentially be a serious risk for small businesses.  The bottom line is this: Each business should examine the classification issue well before its yearend, or you may have to beat your plowshares into swords and your pruning hooks into spears in order to do battle with the IRS.

About The Author

Rick E. Norris, JD, CPA earned a Bachelor of Science from U.C.L.A. in 1979. After receiving his Certified Public Accountant certificate in 1982, he earned a Juris Doctor from Southwestern University School of Law in 1985. He founded Rick E Norris, Accountancy Corporation in 1992. He has published articles in the California CPA Society magazine, among other periodicals, including the company bi-weekly newsletter. He sits on the California CPA Society Entertainment Industry Conference Planning Committee which is held annually in Beverly Hills, CA. Mr. Norris’s firm consults to a variety of small and medium-sized businesses on a variety of strategic planning and business topics.  He is also a board member of the L A Chapter of the Association for Strategic Planning, Cultural Arts Showcase, and the tax-exempt organization, Foundation of Local Arts. In addition to his publications, he speaks frequently at various events in the area of personal and business financial matters.

Rick E Norris, An Accountancy Corp, helps individuals and businesses strategize, plan, and effectively manage their finances and business operations to meet goals and increase personal wealth. In addition to the typical basic accounting and tax services, they offer more. Their specialized services include:

entertainment business management, strategic planning and execution, business plan creation, music royalty analysis, and trust and estate accounting. They customize our services to meet the needs of a rapidly evolving business world. Whether you are in the entertainment industry, or a small to medium size business, they help create your strategy and execute it.

http://www.ricknorriscpa.com

email: ricknorriscpa.com