Independent Contractor or Employee?
If it looks like a duck, walks like a duck and quacks like a duck….it is probably an employee!
We have probably all heard the phrase, “nothing is certain, except death and taxes.” However, another truism is that failure to pay taxes, particularly payroll taxes, can be the direct cause of death of an otherwise viable business. One all too common way of running afoul of the Internal Revenue Service is to treat workers as independent contractors rather than as employees in an attempt to avoid the expense and hassle of withholding taxes and filing payroll tax returns. Often times, the business owner will simply decide to treat an individual as an independent contractor without much thought or concern over the decision. After all, it is a lot easier to simply issue a 1099 statement once a year than it is to fill out new hire documents, withhold taxes, prepare and file payroll returns, issue and file W3 and W2 statements, etc.
However, what every business owner must understand is that the Internal Revenue Service has the authority to exam your business to determine if you have been classifying workers properly. More importantly, if it is determined that you treated a worker as an independent contractor when in fact that person meets the criteria of an employee, the IRS will charge you for ALL payroll taxes that should have been paid for that worker…along with penalties and interest.
Imagine, you have been running a salon, restaurant or other business where you have been treating all of the workers as contractors for several years. The IRS comes in and ultimately assesses you for all of the taxes that should have been paid, (both the employee and employer portions), and, to add insult to injury, they also tack-on penalties and interest. Further, owners can be personally liable for payroll taxes.
Thus, it is absolutely imperative that business owners know the rules before making a decision to treat a worker as an independent contractor. This requires an understanding of the rules and an analysis of the facts of a particular case.
3 primary laws to acknowledge
There are three primary sources of law when it comes to federal taxation:
- Statutory law
- Case law or what is known as “Common Law”
- Regulations or rules.
Each has its purpose and role in our system of law. Statutory law is the written code that states what one can and cannot do. Regulations provide the details and procedures necessary for implementing the statutes. The common law is the court’s way of “fillings in the blanks” when the statutory law is silent or unclear on a particular issue. One must consider all three sources when making a decision on how to classify works.
Regulations concerning the classification of workers can be found in three substantially similar sections of the Employment Tax Regulations, namely:
- Section 31.3121(d)-1 dealing with FICA;
- Section 31.3306(i)-1 dealing with FUTA, and
- Section 31.3410(c)-1 dealing with Federal Income Tax.
The regulations basically provide that an employer/employee relationship exists when the employer simply has the right to control and direct the individual performing the work and that the employer can mandate how and when the result is accomplished.
In contrast, if the employer only has control or direction over the result and not the means and methods utilized to get the result, that individual may be an independent contractor. Similar language can be found in section 31.3306(i)-1(b) and 31.3401(c)-1(b). This is a classic application of substance over form. It doesn’t matter what label the employer or the employee place on the arrangement, such as independent contractor, partner, agent, etc. The major factor is if the employer has control over the “how and when” of the work performed.
Common law factors developed by the courts on a case by case basis over the years include such things as:
- The degree of control exercised by the principal over the details of the work.
- Which party invests in the facilities used in the work.
- The opportunity of the individual for profit or loss.
- Whether or not the principal has the right to discharge the individual.
- Whether the work is part of the principal’s regular business.
- The permanency of the relationship.
- The relationship the parties believe they are creating.
Even this list is non-exhaustive, and the weight of each factor varies depending on the occupation, facts, and circumstances.
New approach to simplifying the classification
The IRS conducted a review of the case law and in 1987 issued a revenue ruling that laid out 20-factors that would be evaluated to determine employment status. This was published as Revenue Ruling 87-41, 1987-1 C.B. 296. However, over time certain factors become obsolete as methods of doing business changed and the application of the 20-factor test was, as one could imagine, cumbersome and difficult to apply. In an effort to simplify the approach, the IRS adopted a new approach that grouped various factors into the following broad categories:
- Behavioral Control;
- Financial Control; and
- Relationship of the Parties.
“Behavioral control” considers whether the business retains the right to direct and control how the worker performs the specific tasks it hired the worker to perform. Factors would include the training and the type and degree of instructions the business gives the worker.
“Financial control” considers whether a business retains the right to direct and control how the business aspects of the worker’s activities are conducted. Factors would include a method of payment; the worker’s opportunity for profit or loss; investment by the worker; expenses incurred by the worker; whether the worker is reimbursed for expenses; and whether the worker provides similar services to others.
“Relationship of the parties” looks at how the parties themselves perceive their relationship. Factors include intent of the parties and their respective rights to terminate their relationship at will.
Now IRS is calling me for an exam! What can I do?
If a business is unfortunate enough to be selected for an employment tax exam and is facing a negative outcome, the business has the ability to seek relief pursuant to section 530 of the Internal Revenue Code. In order to qualify for such relief, the business must meet three requirements:
- Reasonable Basis;
- Substantive Consistency;
- Reporting Consistency.
To meet the Reasonable Basis requirement the business would have to show:
- treatment was based on a federal tax court case or an IRS ruling;
- Your business was previously audited and the IRS did not reclassify similarly situated workers;
- Reliance was based on industry practices; or
- Reliance was based on professional advice sought and received by the business.
To meet the Substantive Consistency requirement, you must have treated similarly situated workers in the same manner. To meet the Reporting Consistency requirement, you must have filed tax forms consistent with the treatment asserted for the worker. If you treated the worker as an independent contractor, you must have issued that worker a 1099 statement consistent with the status you gave them.
Another avenue for addressing the question of status is for the business to seek a determination from the IRS by utilizing Form SS-8. This method is used to request a determination of federal tax matters that are currently at issue and where the statute of limitations has not run. The IRS will not issue a determination for “proposed transactions” or hypothetical situations. The SS-8 form requests information about the company, behavioral control issues, financial control issues and relationship issues. Upon completion of the review, the IRS will issue one of the following:
- Formal Determination Letter – binding on the IRS;
- Information Letter – non-binding and advisory in nature; or
- Courtesy Letter – that a worker may rely on in fulfilling his or her federal tax obligations.
The decision to classify workers as independent contractors or employees is a very serious one which can have profound ramifications on a business. Obviously, it is better to get it right in the beginning than to hope and pray for forgiveness after the fact. If you are not absolutely sure of your decision to classify a worker as an independent contractor, you are strongly encouraged to seek guidance on this issue. Call us first…before the IRS calls you!
Updated on June 30, 2017 10:04