IMGCAP(1)]There is a fuzzy line between a worker who is properly classified as an employee and a worker who is properly classified as an independent contractor.
Despite the imprecise nature of this issue, what is clear is the potentially devastating tax liabilities for a business making an incorrect determination. As a result, it is essential for every business to carefully analyze the status of all of its workers, especially workers being treated as independent contractors, to reduce the chances of misclassification.
For income and employment tax purposes, workers are divided into two broad categories: employees and independent contractors. Deciding which “bucket” a worker belongs in is important because income and employment taxes must be withheld from the compensation paid to each worker who is an employee. On the other hand, no withholding is required on amounts paid to an independent contractor. Treating a worker as an independent contractor who should be treated as an employee may have severe consequences.
If a business fails to withhold and remit income and employment taxes from compensation paid to a worker who is properly classified as an employee, the putative employer may be responsible for all the taxes that should have been withheld and remitted to the government. In addition, interest will be imposed on the amounts owed and penalties may also be assessed. A simple example can help illustrate the stakes.
The withholding for which an employer may be responsible can be significant. In addition to the imposition of interest, penalties may be added to this amount by the IRS. The potential liability becomes even greater if state income and employment taxes are added and if the errors involve multiple employees. The end result is that the business may face a ruinous tax bill.
Determining a Worker’s Status
For federal tax purposes, the general rule for determining whether a worker should be classified as an employee or independent contractor is contained in Internal Revenue Service Regulations Section 31.3121(d)-1(c)(2). This regulation provides that the right to control and direct the individual who performs the services, not only as to the result to be accomplished but also as to the details and means by which that result is accomplished, is indicative of an employer-employee relationship.
In other words, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. An independent contractor, on the other hand, is generally not subject to the control of the recipient of the services as to how the services are to be provided. In essence, an independent contractor is engaged to provide a finished project or job.
The way in which the project or job is completed is left to the discretion of the independent contractor.
Common Factors Considered
In determining whether a business has the ability to exercise the requisite degree of control over the activities of a worker such that he or she should be classified as an employee, an accountant would examine numerous factors.
A sample of some of the most common factors that the IRS and courts examine is listed below.
The 20-Factor Test
For federal tax purposes, a somewhat rigid application of “20 common law factors” listed in IRS Revenue Ruling 87-41 has been used to determine whether a worker was properly classified as an employee or as an independent contractor. These factors, although still applicable, are not as strictly applied as they were in the past.
As set forth in the regulation cited above, the focus in worker classification cases is whether the recipient of the services has the ability to exercise control over the details of how the worker completes his or her tasks.
Alternative Test
Instead of looking to the 20 common-law factors referred to in Rev. Rul. 87-41, courts and the IRS often analyze worker classification cases by examining three broad categories of evidence: behavioral control, financial control, and the relationship of the parties.
Behavioral Control
Factors that are examined in this category include such things as the relationship of the work to the business that is receiving the services, the type and degree of instructions given to a worker by the business that is receiving the services, where the work takes place, and the training provided to the worker by the business.
Generally speaking, the greater the “integration” of the services provided by the worker with the normal operations of the business, the more likely it is that the worker is an employee. Similarly, the greater the volume and detail of the instructions and training provided by a business to a worker, the more likely it is that the worker will be classified as an employee.
Moreover, if the work is performed at a location that belongs to the business (as opposed to the worker’s place of business), the greater the likelihood that the worker will be deemed to be an employee.
Financial Control
The financial control category concerns whether a business retains the right to direct and control how the business aspects of the worker's activities are conducted. The more financial control that the business has over the worker, the greater the chances that the worker will be deemed to be an employee.
The following factors are normally considered when determining if the business has financial control over the worker: (i) whether the worker has a significant investment in his or her business and activities (the less significant the investment the greater the chances that the worker is an employee); (ii) whether the worker incurs significant unreimbursed expenses in his business (generally, an independent contractor is not reimbursed for out of pocket expenses); (iii) whether the worker personally provides his services (the hiring of assistants tends to show that the worker is an independent contractor); (iv) the method used by the business in paying the worker (for example, by the job or by time; paying compensation other than by the job or task indicates that the worker is an employee); and (v) the worker's opportunity for profit or loss (for example, does the worker get compensated for all the time that he or she works, or can the worker realize a “profit” by completing the job more quickly and efficiently, or incur a “loss” by taking longer than planned or incurring greater costs than he or she anticipated; the former tends to show that the worker is an employee).
Relationship of the Parties
This category includes facts that illustrate how the parties perceive their relationship and whether the parties can terminate their relationship at will. Evidence as to how the parties perceive their relationship can be demonstrated, in part, by an agreement as to how the worker will be classified.
A written agreement between the parties (in which both sides were in an equal bargaining position) that designates the worker as an independent contractor or employee is a relevant factor. Typically, an employee can be terminated by the employer at will, or can quit without any liability being incurred. An independent contractor, on the other hand, cannot generally be terminated by a business without incurring liability on the contract that the parties entered into.
Potential Relief Provisions
There are several “relief” provisions under federal law that may apply to reduce a business’ tax liability if it has misclassified workers as independent contractors.
Reduced Withholding Rate
Section 3509(a)(1) of the Internal Revenue Code provides that, if an employer fails to deduct and withhold income taxes on wages paid to an employee as a result of not treating the employee as an employee, the employer's liability for income tax withholding on the employee's wages may be limited to 1.5 percent of the wages paid. Code Section 3509(b)(1) provides that the 1.5 percent amount will increase to 3 percent if the employer has failed to file a Form 1099-MISC with the IRS to report the income paid to the worker, unless the employer can show that the failure is due to reasonable cause and not due to willful neglect.
Similarly, Section 3509(a)(2) provides that, if an employer fails to deduct and withhold the employee’s portion of Social Security (FICA) taxes as a result of not treating the employee as an employee, the employer's liability for these taxes is limited to 20 percent of the “normal” FICA tax.
The reduced withholding rates provided by Code Section 3509 do not apply to the employer’s portion of the employment taxes that it is required to remit to the IRS. Code Section 3509(b)(1) provides that the 20 percent amount will increase to 40 percent if the employer failed to file a Form 1099-MISC with the IRS to report the income paid to the worker, unless the employer can show that the failure is due to reasonable cause and not due to willful neglect
Code Section 3509(c) contains an exception to the reduced withholding rates set forth in Section 3509(a)(1) and (a)(2) set forth above. Section 3509(c) states that the reduced withholding rates will not apply if an employer has intentionally disregarded the requirement to deduct and withhold income tax from the employee's wages.
If the reduced withholding rates set forth in Code Section 3509 do not apply, the only other mitigation provision available is contained in Code Section 3402(d). Section 3402(d) provides that, if an employer fails to deduct and withhold income tax from an employee's compensation, and the tax against which the withholding may be credited is later paid by the employee, the withholding tax that the employer should have deducted and withheld will not be collected from the employer.
The employer, however, will not be relieved of liability for any penalties (and interest) that may otherwise apply as a result of the failure to deduct and withhold the income tax. Moreover, for Section 3402(d) to apply, the employer must prove that the worker paid the employment taxes at issue.
Interest-Free Adjustments
Code Section 6205 and the regulations promulgated there provide that, if an employer fails to withhold and remit income or employment taxes or file a return because it misclassified employees as independent contractors, if the employer corrects the errors within the time prescribed by IRS regulations, the employer may be able to avoid the imposition of interest on the underpayment.
Section 530 Relief
In 1978 Congress enacted a law to provide assistance to taxpayers from the potentially severe consequences of the IRS making a determination that a business should have treated some or all of its workers as employees. This law, which is set forth in Section 530 of the Revenue Act of 1978, does not appear in the Code. It is simply known as "Section 530 relief."
A business may request Section 530 relief where the IRS has made a determination that its workers should be classified as employees but have been treated by the business as independent contractors. If it applies, the Section 530 relief provisions terminate the liability of a business for FICA and FUTA taxes, income tax withholding, and all resulting interest and penalties.
In order to be eligible for Section 530 relief, an employer must meet three requirements: reporting consistency; substantive consistency; and “reasonable basis” authority.
To satisfy the “reporting consistency” requirement, a business must have filed all of its required returns in a manner consistent with treating the workers as independent contractors. In other words, the business must have given each worker a Form 1099-MISC and filed a copy with the IRS.
To satisfy the “substantive consistency” requirement, a business must have treated all similarly situated workers as independent contractors. This means that if a business has treated some workers as employees and other workers who have provided the same (or substantially similar) services as independent contractors, the substantive consistency requirement will not be met.
The “reasonable basis” requirement is generally the most difficult one to meet. To satisfy this requirement, a business must show that, at the time it determined that workers would be treated as independent contractors, it had a reasonable basis for doing so. To show that it had a reasonable basis for treating the workers as independent contractors, the business must show that it relied upon at least one of the following: (i) judicial precedent (includes a published IRS ruling or technical advice memorandum with respect to the business); (ii) a prior examination by the IRS where the issue was addressed; (iii) industry custom or practice; or (iv) other reasonable basis (this includes an opinion from an attorney or CPA).
IRS Classification Settlement Program
The IRS Classification Settlement Program, or CSP, was established in 1996. It is designed to apply to situations where a business has misclassified workers but does not qualify for Section 530 relief.
The CSP permits the IRS to make a settlement offer if the business agrees to prospectively classify the workers in dispute as employees. Under the CSP, a series of graduated settlement offers is available. The actual CSP offer that is made will depend upon how “compliant” the business has been in determining the worker’s status and reporting the amounts paid to the worker.
The line separating an employee from an independent contractor is not a well-defined one. This can make it extremely challenging for a business to determine how to classify its workers. Notwithstanding the complexity of this determination, properly classifying its workers is critical for a business’ financial well being.
A business that has one or more workers classified as independent contractors must ensure that it has carefully evaluated the factors that are commonly looked at by the IRS and the courts when they analyze worker status. Although there are relief provisions that may be available if the government asserts that a misclassification has taken place, the best alternative is to avoid the dispute in the first place.
Jeffrey Davine is a partner in the Los Angeles office of Mitchell Silberberg & Knupp LLP. He is a member of the Taxpayer Advocacy Panel, a federal advisory committee to the Internal Revenue Service.
