Small business owners need to address a variety of small business tax issues, and it is important to comply with all requirements put in place by the IRS and California's Employment Development Department (EDD). Worker misclassification is one issue that has received increasing scrutiny in recent years, and businesses that improperly classify workers as independent contractors instead of employees may face a variety of tax penalties. Recently, the IRS and the federal Department of Labor (DOL) announced that they will be working together to identify tax compliance issues related to worker misclassification This may result in tax audits and penalties for businesses that have failed to follow the proper procedures.

Understanding the Joint Worker Misclassification Initiative

On December 14, 2022, the IRS and the DOL issued a Memorandum of Understanding for Employment Tax Referrals, and this document stated that the agencies will be working together to improve compliance with laws related to worker classification. The Department of Labor's Wage and Hour Division regularly investigates complaints related to the misclassification of workers. Under this initiative, the WHD may refer information related to investigations about alleged worker misclassification to the IRS's Small Business/Self-Employed Specialty Employment Tax unit. The IRS will then evaluate these referrals to determine whether to conduct audits and assess penalties against noncompliant employers.

The Memorandum of Understanding detailed certain requirements that must be met before cases can be referred to the IRS. A business must still be in operation at the time of the referral, and the IRS will typically only investigate businesses that did not have a good-faith basis for misclassifying workers. Referrals will only be made in cases where a business had an annual dollar volume of at least $500,000. That is, the business's gross earnings over a period of 12 months must be $500,000 or more.

If you are a small business owner, you may be aware that there are multiple different types of taxes that you need to pay. Self-employment taxes are the combined Social Security and Medicare taxes that sole proprietors, independent contractors, and other types of business owners must pay. Understanding the self-employment taxes that may apply to you can help you make sure you stay compliant with the law and will not be required to pay penalties or fees. 

Understanding Self-Employment Tax

You will generally be required to pay the self-employment tax (also known as SE tax) if you have net earnings of at least $400 from self-employment in a tax year. The SE tax rate is currently 15.3 percent, which consists of 12.4 percent for Social Security taxes and 2.9 percent for Medicare taxes. In 2022, the Social Security portion of the self-employment tax will apply to the first $147,000 of your net earnings, including wages or tips. All combined earnings will be subject to the Medicare portion of the self-employment tax.

Self-Employment Tax Vs. Income Taxes 

In addition to paying SE tax, small business owners also have the obligation of paying income taxes. These taxes will apply to the salary you pay yourself through your business. For businesses that are classified as pass-through entities, including S corporations or LLCs, the profits earned by the business will be "passed through" to the owner, and they will be subject to income taxes. If your business is a sole proprietorship, it will not be separate from the salary you pay yourself, and you will be required to pay income taxes on all business earnings.

The classification of workers as employees or independent contractors is an important legal distinction that can have significant implications for employers. Employees are entitled to a number of rights and protections under the law, including minimum wage and overtime pay, while independent contractors are not. It is important for employers to ensure that workers are classified correctly, and they may face penalties if they fail to do so. Recently, the Department of Labor announced a proposed rule that may affect worker classification. Employers will need to understand how this rule could affect them and how they can avoid the potential risks of misclassifying workers.

Potential Changes to Federal Worker Classification Rules

The Department of Labor follows certain rules when determining worker status under the Fair Labor Standards Act (FLSA). During the administration of President Donald Trump, these rules were updated to focus on two "core factors": the degree of control that an employer and/or worker has regarding key aspects of the work being performed, and a person's opportunities for profits and losses when performing work. This rule was generally considered to favor employers, allowing them to classify more workers as independent contractors.

The administration of President Joe Biden is seeking to put new rules in place that will protect the rights of workers. The proposed new rule would look at the "totality of the circumstances" that may affect a worker, and it would include six factors to consider:

As a small business owner, it is important to be aware of the various tax deductions that are available to you. Taking advantage of these deductions can help reduce your tax liability, leaving you with more money to reinvest in your business. By working with a tax law attorney, you can determine the best ways to minimize your tax burden and ensure that your business will be able to continue operating successfully. 

Tax Deductions for Business Expenses and Other Costs

There are multiple types of expenses that small business owners may be able to deduct from their taxes, including:

• Startup costs - A business's capital expenses may address the costs of starting a company. Deductions may be available for the costs of founding or acquiring a business, and these may be amortized over several years after a business is founded.

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During the business formation process, a business’s owner, partners, investors, or shareholders will need to determine how the business will be structured. The selection of a business entity may determine how a company will be organized and managed, and it will also affect the taxes that the business will need to pay. By understanding how taxes apply to different types of business structures, owners or partners can determine which type of business entity will provide them with the most benefits.

Taxation for Different Types of Business Entities

The structure of a business will determine whether income taxes will apply to the business itself or to its owners, partners, and shareholders. If a business is a pass-through entity, profits and losses will be passed through to those who have an ownership share in the business, and individual income taxes will apply to these amounts. 

Some commonly used business entities are taxed as follows: