Is Withholding Taxes On Sales Commissions “B.S.”?

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Question: I just started working for a construction contractor, helping him find leads for future customers. He says he wants to “minimize risk” while paying me commissions on any jobs I give him leads on. That means I have to choose between:

1. letting him take withholding taxes from my commissions, or

2. filing for an LLC or a corporation.

I am a sole proprietorship. People are supposed to send me 1099s, but he’s not going to do that unless I have a corporation or an LLC. Is he really minimizing his risk? Or is this B.S. or what?

— Pete in California

Is it B.S.? Yes and no. I would call it an “imperfect application of common tax principal.” Let me explain.

In the small business world, there are few words more dangerous than “employee.” It’s a dangerous word because businesses with employees have many additional requirements — and pay extra taxes — than businesses with independent contractors alone.

For example, businesses with employees are required to…

  • withhold income and FICA tax from employee paychecks
  • pay 50 percent of the 15.3 percent FICA tax for each employee
  • file and pay payroll taxes
  • issue annual W-2 forms, among others

Because many small businesses want to avoid the extra time and expense needed for carrying official employees, there is pressure to classify as many workers as possible as independent contractors.

But the test on whether a worker is an employee or independent contractors has nothing to do with the label attached to the relationship. Rather, it’s how much control the small business has over the worker: scheduling, training, evaluation systems, degree of instruction, etc.

Distinguishing employee from contractor

The more control, the more likely that worker is an employee and not an independent contractor.

The IRS has the power to reclassify workers as independent contractors, and when they do, they can levy massive penalties on a small business.

Many small businesses think they can limit the risk of an IRS reclassification challenge by requiring their independent contractors to obtain an EIN. “If a business is paying another business,” the thinking goes, “the relationship is more likely to be considered an independent contractor relationship and not an employer/employee relationship!”

However, the test on whether a worker is an employee or independent contractor is based much more on control than on the labels the parties attach to one another. So paying a person with an SSN or a business with an EIN doesn’t make much difference.

Now, with all that in mind, let’s get to today’s question…

Based on the facts, it appears the construction contractor is giving you the choice of being classified as an employee and having taxes taken out, or as an independent contractor. If you choose the independent contractor route, the construction contractor is trying to limit the risk of you later being considered an employee and IRS levying penalties against it. But, again, it’s about control much more than it is about labels.

I struggle to call this “B.S.” because I think the employer sincerely is trying to limit its risk. But if IRS ever investigated the classification, they will be looking at the control the contractor has over you and not whether they put an SSN or an EIN on their paperwork. As such, I wouldn’t call the contractor’s EIN requirement B.S. — but rather an imperfect application of a common tax principal.

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Originally published at www.debt.com on May 23, 2018.

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