Employee Vs. Contractor: What You Don’t Know Could Bankrupt You
At The 2018 NAMM Show, music industry accountants Alan Friedman, CPA, and Daniel Jobe of Friedman, Kannenberg & Co. discussed recent trends that affect all music retail and lesson studio owners who employ staff. Friedman and Jobe advised everyone to understand the pros and cons of classifying staff as employees versus independent contractors, so you clearly know which way to lean. (Note: This article and video do not constitute legal advice. Please read NAMM U’s legal disclaimer.)
According to Friedman and Jobe, there’s been a movement for states to audit music retailers for worker classification. You could be held liable for taxes—social security, federal and state payroll taxes, unemployment and other benefits—if the employment status of a worker is incorrect. Friedman and Jobe cautioned that this goes beyond music teachers to include repair and office staff.
For years, it was common for music stores and vibrant music lesson programs to have teachers classified as independent contractors. Friedman and Jobe commented that more stores are flipping their music teachers from independent contractors to employees due to tougher regulations. Even if you meet federal requirements, the states are more stringent about classification.
Here are facts that you’ll want to be aware of:
Employee Pros and Cons
An employee is employed on a regular basis, and you are withholding taxes. Pros include: controlling the work schedule, teaching methods, teaching rates, compensation and benefits, as well as dealing with limited issues with tax authorities. Cons include: the burden of payroll taxes (which vary from state to state), unemployment taxes, worker’s comp and health insurance, retirement and other benefits.
Independent Contractor Pros and Cons
Independent contractors are free to work wherever and for whomever. Pros include: no payroll taxes, insurance costs, retirement benefits, employment benefits or payroll accounting, as well as minimized tax reporting. Cons include: no control over a work schedule, teaching methods, teaching rates, where they can’t teach, what they wear and what to sell to students.
Employee vs. Renter
Given the costs associated with employees and the risks associated with independent contractors, a safer route may be to rent rooms instead. You can rent lesson rooms to music teachers, which essentially renders them tenants. But like everything else, there are inherent limitations, both financial and in terms of control over the curriculum and teaching quality, in renting rooms versus employing or engaging teachers.
Treating teachers as independent contractors can be an issue. It means teachers can earn money without being told what to do, when to do it and where to be. It gets problematic when you try to exercise any control over their curriculum and when and where they teach. If you try to control the teacher, you will likely fail an audit, and you can bring high exposure and financial harm to yourself—making you accountable for back federal and state payroll taxes, back unemployment taxes and back employment benefits.
Federal IRS Guidelines
Employee status is determined based on the degree of control in three categories:
1. Behavioral control: Facts that show whether the business has a right to direct and control how the worker does the tasks for which the worker is hired. This includes when and where to work, how to do the work, who does the work, training and use of subcontractors (in repair, this comes up a lot).
Takeaway: If you tell someone what to do, when to work and how to do it, they are probably an employee!
2. Financial control: Facts that show whether the business has a right to control the business aspects of the worker’s job. This includes who pays for business expenses, who made the business investment (i.e., facilities or equipment needed), whether the person’s services are available to the general public, how payments are made (on an hourly basis or project/fixed fee) and realization of profit or loss. It’s critical to check your state labor laws through the state Department of Labor. Friedman and Jobe recommended consulting a labor attorney in your state with any questions.
Takeaway: If the person performing the work does not experience the same business pressures you feel, they are probably not running their own business and are, in reality, an employee!
3. Type of relationship: Facts that show the parties’ type of relationship. This includes the length of a relationship, how the relationship is ended, who may terminate the relationship and key aspects of the business. Friedman and Jobe commented that they’ve found this hasn’t come into play as much.
Takeaway: Independent contractors are free to work wherever and for whomever. If you would like to dictate this, they should probably be an employee.
Which Form Do You Use?
• Employee: W-4 and W-2 at year-end
• Independent Contractors: W-9 (always get one of these filled out) and 1099-MISC at year-end
Structure the Relationship
To best assure a favorable outcome in the event of scrutiny by any tax authority, you should:
• Have written contracts or agreements with your music teachers.
• Have an attorney review all documents.
• If need be, request assistance from the IRS in determining status by filing a Federal Form SS-8. The IRS will give you a definitive ruling.
Best Practice: Making Certain of Independence
The independent contractor should provide: an invoice for payment, services to other businesses besides yours, a certificate of liability insurance and a signed agreement (per project) for services rendered.