Small Business - Important Terms Defined

Posted on June 9, 2024

THE BUSINESS OWNER

The definition of a small business is a type of business entity that is owned and run by one individual (the proprietor) and in which there is no legal distinction between the owner & the business. The owner receives all profits ( subject to taxation specific to the business) and has unlimited responsibility for all losses and debts. Every asset of the business is owned by the proprietor and all debts of the business are the proprietors.

A sole proprietor may use a trade name or a business name, other than his or her legal name. In the United States, there is generally a requirement to file a doing business as (DBA) statement with the local authorities, such as the respective county. The difference between a sole proprietor (small business) and a corporation or a partnership is that the latter are separate legal entities. Those entities require a separate tax-return to be filed. An Employer Identification Number (EIN) can be obtained from the IRS. A sole proprietor will file a personal tax return (Form 1040) with a Schedule C.

The Business Owner and Employees

If an individual has employees, they will need to file forms to report employment taxes. These items are reported to employees on Form W-2 Wage and Tax Statement. An employer is also responsible for submitting the same W-2 information to the IRS. Both paper and electronic filing have a due date of January 31st. These employment taxes are also expenses to the business:

• Social security and Medicare Taxes
• Federal income tax withholding
• Federal unemployment (FUTA) tax

What is an Independent Contractor ?

People such as doctors, dentist, accountants, lawyers, contractors, subcontractors, who are in an independent trade or business or profession, in which they offer their services to the general public are generally independent contractors. However, whether they are independent contractors or employees, depends on the facts of each case.

General Rules:

• An individual is an independent contractor if the payer has the right to control or to direct only the result of the work and not how it will be done.
• The earnings of a person who is working as an independent contractor are subject to self-employment tax.
• Form 1099-NEC Non Employee Compensation is used to report non-employee compensation to the IRS.
• Independent contractors may receive a 1099-NEC. If the payer paid $600 or more to a non-employee (independent contractor), a 1099-NEC must be issued to the payee.
• The 1099-NEC must be submitted to the payee by January 31st of the following year and it must also be submitted to the IRS (Internal Revenue Service) by the end of February.

Independent Contractor vs. Employee

For small business owners, choosing between hiring employees or independent contractors is an important decision that would impact working relationships and taxation issues. The employer should be aware of the tax responsibilities in both the scenarios.

Relationship and Control Defined

There are three tests in order to define relationships and control:

• Behavioral Control: Does the employer have the right to direct and control how the work for which they were hired is completed ?
• Financial Control: An independent contractor is likely to have unreimbursed business expenses, have a significant investment in the facilities or tools they use, can make their services available to the relevant market and is usually paid a flat fee.
• Type of relationship: Under this factor are the services the worker is performing - Are they a key aspect of the regular business of the company ? If "yes" the individual is an "employee".

Tax Treatment Differences Between Employees and Independent Contractors

For Employees:

• The employer must withhold State and Federal Income tax
• The employer must withhold Social Security Tax
• The employer must withhold Medicare Tax
• The employer must pay Unemployment tax on wages
• The employer must complete a W-2 form for each employee

For Independent Contractors:

• Employers do not have to worry about the above tax issues for independent contractors. Independent contractors handle taxes related to Social Security, Medicare etc.
• Employers have to produce a W-9 to be completed by the independent contractor.
• An employer may have to file information returns (Form 1099-NEC) to report certain types of payments made to independent contractors. Generally, any payment in excess of $600 will require a 1099-NEC form.

The California Labor Code makes it unlawful to willfully misclassify individuals as independent contractors. Willfully means either misclassifying the individual intentionally, voluntarily or knowingly. If an employer misclassified an employee as an independent contractor, he can be liable for paying employment taxes for that worker. If the IRS suspects fraud or intentional misconduct, penalties or fines may be imposed.