Contractors should be wary of three compensation pitfalls

By Randy Bonnecaze

As one of your most substantial expenses, labor costs probably command much of your attention throughout the year. Be careful: The IRS is watching, too. In fact, it issued a consumer alert last year informing employers of three compensation pitfalls to watch out for:

1. Improper reporting. The alert warns of "pyramiding." This is the practice of withholding an employee's taxes but failing to remit those taxes to the government, typically because of poor cash flow. Unfortunately, these liabilities quickly "pyramid" and create an insurmountable tax burden. Closely monitoring and maintaining your cash flow can prevent this pyramid effect.

Pyramiding may also strike if you engage the services of a third party to file your employment tax returns and to make the related employee tax payments, or if you lease workers from an outside firm. Although many of these companies are reliable, some may fail to forward collected taxes to the IRS on your behalf.

Exercise care in choosing a third-party representative and carefully monitor the services of any you do engage. Should your tax liability go unpaid, you can become personally liable - regardless of your business structure.

2. Illegitimate arrangements. Subcontracting is common in the construction industry. Classifying a worker as an independent contractor rather than an employee eliminates your need to pay his or her payroll taxes.

But the IRS particularly scrutinizes these situations. Generally, if you control the type of work and how it's to be done, the individual could be reclassified as an employee, leaving you vulnerable to employment taxes on his or her wages in addition to penalties.

The IRS is likely to pursue misdoings in this area based on whatever information it can find.

3. "Unreasonable" salaries. Many construction companies are set up as S corporations. Owners of these businesses often draw cash from their companies as a distribution.

If you follow this tactic, be careful. The IRS still considers S corporation officers as employees, and your wages are subject to employment taxes. To avoid trouble, you're probably better off drawing a reasonable salary, withholding the necessary payroll taxes and then taking additional payments as distributions.

Although compliance requirements may seem to grow more complicated every year, the need for reporting compensation properly and interpreting tax law accurately cannot be overestimated. Put forth a little extra effort today to prevent a much more difficult and unpleasant challenge tomorrow.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.