If you make cash payments to independent contractors, the first thing you should know is that doing so is not inherently illegal. Cash is still an excellent method of payment, as well as being legal tender. Beside that point, due to certain legal restrictions, some industries are stuck using a cash-based system anyway; such is the case with the state-legalized cannabis industry.
If you have cash on hand and want to pay your contractors with it, you technically can do so.
If you are audited by the California Employment Development Department (EDD) or the Internal Revenue Service (IRS) you must prove that your cash payments to the contractors were within legal parameters.
The Viewpoint of the Government on Cash Payments
You must have a reason for paying in cash rather than using checks or electronic transfers (which create a record of your transactions).
State and federal tax authorities almost always think you have some hidden agenda when you pay in cash. They think you are doing that so you can:
- Avoid paying payroll taxes
- Assist the contractor in avoiding his or her income tax obligations
- Falsely report your company’s expenses in order to reduce taxable income
In either case, the penalties can be severe, so you should hire a skilled tax lawyer to help you avoid serious consequences if you are accused of one of those activities. You should proceed with caution if you are facing an audit or investigation for paying contractors in cash. Even if you did not intend to break the law, you may still be in jeopardy. This is one case where you want to be sure that your books are in order and double-checked.
One difference between independent contractors and employees is that employees have some of their wage withheld for Social Security and Medicare. Independent contracts instead have to pay self-employment taxes, as if they were a small corporation.
Penalties for Unreported or Incorrectly Reported Cash Payments
California State Payroll Taxes
If you didn’t pay the state payroll taxes related to your cash payments and the contractors should have been categorized as employees, then you will have to deal with the EDD. The EDD aggressively enforces employers’ payroll tax obligations. In addition to paying all past-due payroll taxes, you would have to pay interest and a 15% fine.
California State Income Taxes
Not paying California state income taxes also triggers interest and penalties. This includes a standard penalty of 5% of the total amount due. This can rise to up to 25% of the total amount due. It’s possible the State of California may deem your using cash to pay contractors as a way for your contractors to avoid paying state income tax.
Federal Payroll and Income Taxes
Payroll or income tax evasion is a serious offense that can result in an IRS investigation. This is the worst-case scenario, and it is a real possibility for business owners accused of defrauding the federal government by using cash payments.
Speak with an experienced tax attorney if you need help or advice