You may be aware that as an investor in the real estate business, you can save tons of money each year in taxes by hiring independent contractors rather than employees, as you can avoid paying, withholding, and filing costs each and every year for your independent contractors that you would otherwise incur with an employee.
It should come as no surprise to you that the IRS has been working hard to close this amazing loophole as part of its efforts to raise tax revenue. I met a man who owned a mortgage company and paid all his sales people as independent contractors. He got under a brutal IRS audit and ended up losing EVERYTHING…his business, his investments, and his home. Needless to say, the IRS will continue to enforce this area of the tax code because it is a high revenue generator for the Treasury Department. So what does this mean for you as an investor? This means that you need to protect yourself! If you have independent contractors in your investing business, you need to make sure you have all the correct documentation to protect yourself in case of an audit.
How to Protect Yourself
In order to protect your real estate business from the auditor, you first need to know “how” they conduct their audits in this area. Currently, the IRS agents take a special class that trains them on how to audit worker classification of small businesses. The good news is that the materials in this auditor training course are actually available for us to see! We can all access the IRS playbook and learn about “how” they plan to audit our real estate businesses! This manual, entitled “Independent Contractor or Employee?”, is available at www.irs.gov/pub/irs-utl/emporind.pdf.
If you aren’t too excited about reading through all 160 pages of the manual, you are in luck. Here is a highlight of the important areas that you need to know.
Independent Contractor or Employee Qualifications
The auditors are taught to analyze the employee versus independent contractor status of your workers using a series of seven factors. These factors are:
1) Degree of control exercised by the principal.
2) The worker’s investment in facilities.
3) The opportunity of the worker for profit and loss.
4) The right of discharge.
5) Whether the services performed were part of the principal’s regular business.
6) The permanency of the relationship.
7) The intent of the parties.
In addition, the auditors focus on the dynamics between the employer and the worker in terms of behavioral control, financial control and relationship of the parties. In short, the IRS wants you to have little or no control in the behavior and finances of your workers in order for them to be classified as independent contractors. The more financial and behavioral control the employer has, the more likely the relationship is one of employer/employee.
As an example, a general contractor was able to qualify as an independent contractor and not an employee because the contractor:
1) Controlled the manner in which he scheduled work hours.
2) Invested a significant amount of money in his equipment and supplies.
3) Had other clients that he worked as a general contractor for
4) Operated out of his own legal entity
Audit Protection Checklist
Now that you know “how “ the IRS looks at the independent contractor status when doing their audits, here are some things you can put in place to protect yourself in case of an audit:
1.) Create a job description for the position which indicate limited control and an independent working environment
2.) Ensure your Company’s operating agreement and employment policies treat the position as an independent contractor
3.) Get a signed independent contractor’s agreement between the Company and the worker
4.) Have a completed Form W-9 from each independent contractor you hire
Real Estate Investor Must Do’s
We all know that as real estate investors, a lot of times we hire temporary workers to help out for things like repairs, maintenance, or landscaping. In an effort to avoid taxes, your temporary workers may request that you do not even issue them a 1099 at all. It is important for you to know that issuing the 1099 to your temporary workers protects you and helps you to prove that the money you spent was a legitimate business expense. So be sure to take that extra step to issue the 1099 to your contactors when appropriate so that you are protected in case of a future audit.
As we discussed, independent contractors are a great way to efficiently add to your investment company. Savings in money and resources can make hiring independent contractors an attractive alternative to hiring employees. Now that you know the IRS playbook, you are armed with the strategies that can help you to safely maneuver potential future audits.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.