By Dave Horwedel, EA, founder of Torchlight Tax
The world changes. For many years, employers saved dollars by employing contractors. This is still a good strategy for some, but others may profit from a different approach.
In 2020 and 2021, companies with W2 employers were heavily benefited by forgivable Payroll Protection Program (PPP) loans and the Employee Retention Credit (ERC). An employer with 20 W2 employees who qualified could receive over half a million dollars in refunds.
Had the same company paid the same money to 1099 contractors, the company would be eligible for NONE of this. Big Difference!
If you received the ERC, and are concerned that you might be audited, or if you did not receive the ERC, and wonder if you missed out, you should visit my blog at TorchlightTax.com or my YouTube channel Torchlight Tax and watch my ERC videos.. You can also contact us at 1 877-758-7797 for a free consultation or email us at firstname.lastname@example.org.
(There is tremendous amount of baloney being spread about on the ERC, and employers are being badly mis-advised. Qualified employers have been told they do not qualify, and non-qualified employees have been told they do.)
There are various rules as to who qualifies as an independent contractor, as opposed to who qualifies as an employees, and this is covered in a different article.
The advantage of contractors, if legitimate, is that they can be paid based on their production. One could have a plumbing company that scheduled plumbing jobs to a contractor who was fully responsible for the work he did and collected a percentage of the fee.
This way the company is not stuck having to pay for work poorly done and never collected on. The plumbers must work hard, complete jobs, and make sure the money is collected. They are solely responsible for his own taxes.
The employer does not have to worry about his payroll taxes, and if the contractors do not do a volume of good, completed jobs, the employer is not stuck with a huge payroll bill and no products.
On the flip side, the company must be very alert to breaking the contractor rules. If they do so they can open themselves up to lawsuits from former contractors, action by state employment departments, and audits from the IRS and state taxing authorities.
Also, S Corporations are sometimes remiss and do not pay their shareholder-employees on a W2 as they are supposed to. They are required to at least pay “Reasonable Compensation” by
W2. Then the shareholder can have tax savings on the balance of the profit that flows through to him. There can be substantial savings to a share-holder employee in having an S-Corp and a proper payroll that pays reasonable compensation by W2.
Paying zero payroll—especially year after year– is not a good idea, and if an S Corp has been doing this, they should correct it right away. Your best safe strategy is to pay as little Reasonable Compensation as you can justify, and thus safely enjoy the tax savings on your flow-through profit.
Also, employers must be alert to state laws. One California Employer paid his W2 employees a 50% commission. They were not 1099 contractors, and they were not on hourly pay. Now an attorney is suing the employer for not paying them for lunch and dinner breaks and may very well win.
The employer has corrected this now. All the employer had to do is pay them on an hourly rate, including lunch and dinner time, and then give them an additional bonus to bring them up to 50% commission. The cost is the same. The employees get the same pay. However, the employer is not liable for a lawsuit because he paid them for their lunch and inner time.
If you need help in setting up your payroll correctly, or indeed in working out long-term strategies to save tax dollars legal, please contact Torchlight Tax at 877-758-7797 for a free consultation. You can also visit our blog or the Torchlight Tax YouTube Channel to learn more.
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Below is the article direct from the IRS website explaining third-party payroll services, verbatim from the IRS website.
Picking the right third-party payroll service provider helps protect businesses
IRS Tax Tip 2023-65, May 10, 2023
Not all third-party payroll service providers are created equal. A trusted, qualified company can help keep businesses secure and tax compliant. An unreliable or fraudulent company can lead to missed deposits, theft or returns not being filed.
While many third-party payroll service providers give quality service, unprofessional or fraudulent companies will take the money and run – accepting a customer’s payroll taxes and closing without warning. This is costly for the affected business because it’s legally responsible for reporting and paying the taxes due, even if it sent funds to the third-party payroll service provider for required deposits and payments.
Businesses can protect themselves by hiring a one of these trusted providers:
- Certified professional employer organization. Generally, these organizations are solely liable to file employment tax returns and make deposits and payments for the taxes their customers report for wages and other compensation. CPEOs file employment tax returns and deposits and pay their customers’ combined tax liabilities with the CPEO’s Employer Identification number. An employer enters into a service contract with a CPEO and the CPEO submits to the IRS Form 8973, Certified Professional Employer Organization/Customer Reporting Agreement. Employers can find a CPEO on Public Listingsat IRS.gov.
- Reporting agent. This is a third-party payroll service provider that must deposit a customer’s taxes with the Electronic Federal Tax Payment System. Reporting agents generally can share customers’ information with the IRS to resolve issues. They must also provide customers with a written statement reminding them that the employer, not the reporting agent, is responsible for filing tax returns and paying taxes on time. To inform the IRS of its relationship with a customer, reporting agents submit Form 8655, Reporting Agent Authorization, which the customer signs.
- Section 3504 agent. This third-party payroll service provider withholds, reports and pays employment taxes for the employer. A section 3504 agent assumes liability along with the employer for the employer’s Social Security, Medicare and federal income tax withholding responsibilities. The agent combines all the returns for its employer customers and submits them with the agent’s EIN. Generally, employers who use a section 3504 agent must still file FUTA tax returns with their own EINs. To request the IRS to authorize a third party as an agent of the employer, the employer submits Form 2678, Employer/Payer Appointment of Agent.
The IRS encourages employers to enroll in EFTPS and make sure its third-party payroll service provider uses EFTPS to make tax deposits. It’s free and it gives employers safe and easy online access to their payment history for deposits made with their EIN. This helps them monitor whether their third-party payroll service provider meets its tax deposit responsibilities.
Employers should contact the IRS about any bills or notices they receive, especially if the bill or notice relates to payments managed by a third party. Call the number on the bill, write to the IRS office that sent the bill or contact the IRS business tax hotline at 800-829-4933.