Finis Cowan, Attorney - Retired CPA

Key Points:

• Employers misclassifying employees can be liable for the employees taxes and penalties.

• Employees are subject to employers control regarding what will be done and how it will be done. If the employer retains the right to direct and control the means and details of the work, then the worker is an employee. Reg. Sec. 31.3121(d)-(1)(c), paragraphs (1) and (2).
• In contrast, an independent contractor who performs services for you, but you control only the result of the work, not the means and methods of accomplishing the result.

Employee versus Independent Contractor

Right to dictate how work is performed

Non-competition agreement

Services available to others, Advertises

Continuous basis

Hired to perform discreet job

Services are critical to purpose of business

therefore control expected.

Profit/loss potential, investment

Compensation imposed, standard

Compensation negotiated per job or lockstep

Perceived as employers representative 

Works under separate business name

Employer imposes schedule

Must notify employer if not coming in

Needs employers permission to make

decisions on hiring and spending Free to hire own help

Misguided employers mistakenly think they can just opt out of the payroll tax system of laws to avoid the expense and hassle of withholding taxes, matching FICA and paying unemployment insurance. Sometimes entire groups of employees or employers are persuaded to opt out and they generally all end up in serious tax trouble. If it was this easy to evade the law, everyone would do it.

Sometimes even well educated employers that should know better, e.g., lawyers with secretaries, attempt this end run around the law to their deep regret. The secretary was subject to intensely minute control over the details of how she performed her work and was an employee in every other sense of the word: regular long-term full-time attendance at the employers workplace, use of the employers equipment and supplies, trained and (as required by canons of ethics) closely supervised by the lawyer. Her services were exclusively performed for the one employer. When she was investigated by the IRS two years later, we advised her to file the proper IRS form along with documentation from her former employer listing the conditions and rules of her employment. The lawyer was held liable for all back taxes, interest and very substantial penalties. Had the case been egregious enough, criminal prosecution would be a possibility.

First, lets look at behavioral control. The key issues for behavioral control are instructions and training.

Types of instructions include things like:

• When and where to do the work
• What tools or equipment to use
• What workers to hire or to assist with the work
• Where to purchase supplies and services
• What work must be performed by a specified individual, and
• What order or sequence to follow when performing the work

You would also want to consider the degree of instruction. The more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.

The business does not have to actually direct or control the way the work is done as long as the employer has the right to direct and control the work. For example:

Instructions if you receive extensive instructions on how work is to be done, this suggests that you are an employee. Instructions can cover a wide range of topics, for example:

how, when, or where to do the work

what tools or equipment to use

what assistants to hire to help with the work

where to purchase supplies and services

If you receive less extensive instructions about what should be done, but not how it should be done, you may be an independent contractor. For instance, instructions about time and place may be less important than directions on how the work is performed.

Training if the business provides you with training about required procedures and methods, this indicates that the business wants the work done in a certain way, and this suggests that you may be an employee. Training means explaining detailed methods and procedures to be used in performing a task. If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee. Periodic or ongoing training about procedures and methods is even stronger evidence of an employer-employee relationship.

The next factor under behavioral contol is the evaluation system. If an evaluation system measures the details of how the work is performed, then these factors could point to an employee. On the other hand, if the evaluation system measures just the end result, then this could point to either an independent contractor or an employee.

When looking at behavioral control, the key factor to consider is whether the business retains the right to control the worker and the details of how the services are performed, regardless of whether the business actually exercises that right.

Heres an example:
A plumber agrees to install plumbing in a new warehouse being built. Upon arriving at the warehouse, the plumber is given the building plans showing where the plumbing is to be installed, and advised that the plumbing must be completed within five days. This is direction of what is to be done, rather than how it is to be done and is consistent with independent contractor status.

Heres another example that points more to an employee:
A plumber works out of the local plumbers union office. The warehouse general contractor tells the plumber what plumbing has to be done, gives specific instructions on installation, the tools to use, the type of pipe to use, and the order and sequence in which the plumbing is to be installed. These are specific instructions on how the work is to be performed and are consistent with employee status.

Now let's look at the second category of evidence, financial control.

Financial control refers to whether or not the business has the right to direct and control the financial aspects of the workers job. Lets talk about several different ways a business exercises financial control.

First, theres investment. An independent contractor often has a significant investment in the equipment he or she uses in working for someone else. However, in many occupations, such as construction, workers spend hundreds of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment. Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures.

Next are expenses. Employers are more likely to reimburse employees for their job expenses, while businesses usually do not reimburse independent contractors for expenses. However, employees may also incur expenses that are not reimbursed.

Heres an example:
A teacher buys erasers, posters and other minor supplies throughout the year.
She is not reimbursed for these expenses, but minor expenses incurred by an employee do not indicate an independent contractor relationship. She is an employee.

The opportunity to make a profit or loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money for example, their expenses will exceed their income from the work. The possibility of incurring a loss indicates that the worker is an independent contractor.

We also want to consider the availability of services. Are the workers services available to the market? Independent contractors often advertise, maintain a visible business location and are available for the relevant market. Also, an independent contractor is generally free to seek out business opportunities.

Finally, the method of payment must be considered. What type of payment does the worker receive? Is he paid by the job or the hour? Hourly, weekly, or similar basis for payment in return for labor generally is evidence of an employer-employee relationship. A flat fee is generally evidence of an independent contractor, especially if the worker incurs the expenses of performing the services. Furthermore, if a worker continues to be paid during down time, this is evidence the worker is an employee.

Again, just as with the behavioral control factors, there is no one factor that takes precedence over the others. Its a matter of looking at the whole relationship and seeing where the preponderance of evidence lies.

The third category of evidence is the relationship of the parties.

Lets take a look at some of the elements that may be present in the type of relationship between the two parties.

Is there a written contract? Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the workers status. The IRS is not required to follow a contract that simply statesthat the worker is an independent contractor, responsible for paying his or her own self-employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.

• Are employee-type benefits provided? Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.
• How permanent is the relationship? If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship. As mentioned earlier, if the worker continues to be paid during down periods, this points toward a more permanent employer-employee relationship.
• Are the services provided a key activity of the business? If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, a baker is a key element in the bakery business. It is likely that the bakerywould have the right to control or direct that work of the baker because his or her success determines the success of the bakery. This would indicate an employer-employee relationship.

We often get questions from business owners about how to treat casual labor or day labor. For each worker you will need to look at all of the factors weve just discussed, and see whether they indicate an employee or an independent contractor. The length of time the worker performs services for you is not a stand-alone factor in determining his or her status. A worker can be an employee even if he or she only performs a few hours of services.

What if youre still not sure?

After reviewing these three categories of evidence, if you are still unsure whether a worker is an employee or an independent contractor, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the workers status.

The IRS does not charge a user fee for an SS-8 determination, but you should expect to wait at least at least six months for the determination, especially as the volume of SS-8s increases. However, it may be worth it for a business that will continually hire the same types of workers to perform particular services.

Form 8919

There may be circumstances where a determination has been made that a worker is an employee, however, the employer continues to treat the worker as an independent contractor and issue him or her a Form 1099 in lieu of a W-2.Form 8919, entitled Uncollected Social Security and Medicare Tax on Wages is now available for this situation. Workers who believe they have been improperly classified as independent contractors can use this form to tell the IRS they believe they should be employees, and report only their share of Social Security and Medicare taxes in lieu of self-employment tax. This form is attached to Form 1040.

On the form, workers must select one of eight reasons why they believe they were employees rather than independent contractors. For some of the reason codes, a Form SS-8 must already have been filed. For others, the worker is required to file the SS-8 before filing his or her tax return.

Let's talk about officer compensation.

You might think you might have to go through all these tests to determine the worker status for officers, but you dont, because officers are specifically included within the definition of employees for purposes of FICA, FUTA, and federal income tax withholding. Officers are employees by statute under Internal Revenue Code section 3121(d)(1).

The common law standard is not applicable. However, there is a narrow exception. An officer is not considered to be an employee of the corporation if two requirements are met:

• One: the officer does not perform any services or performs only minor services; and
• Two: the officer is not entitled to receive, directly or indirectly, any remuneration.

Sometimes corporations attempt to compensate officers for their services using methods other than wages. These can include:

• Distributions
• Loans to shareholders
• Payments of personal expenses
• Excessive rent payments
• Management fees and/or
• Fringe benefits

There are several court cases and rulings indicating that the IRS has the authority to reclassify all or part of these payments made to a corporate officer as wages.

Misclassification of Workers

As we have seen, the status of a worker as either an independent contractor or an employee must be determined accurately in order to ensure that workers and businesses can anticipate and meet their tax responsibilities. Businesses decide whether to hire employees or independent contractors depending on individual needs, customer expectations, and worker availability. Either worker classification independent contractor or employee can be a valid and appropriate business choice.

The majority of classifications of workers are not challenged by the IRS. However, when IRS reclassifications are made, it can result in the assessment of significant employment tax liabilities. Congress recognized this in 1978 and passed Section 530 of the Revenue Act of 1978. Section 530 provides businesses with relief from federal employment tax obligations if certain requirements are met. It terminates the businesss, but not the workers, liability for the following employment taxes: federal income tax withholding, Social Security and Medicare taxes (FICA), and Federal Unemployment Tax (FUTA). It also means the business is not required to pay any interest or penalties resulting from the liability for employment taxes.

Information on Section 530 relief can be found in Publication 1976(PDF), titled Section 530 Relief Requirements. This publication is on the IRS Web site.

Section 530 Relief Requirements

Now lets take a few minutes to address the application of Section 530 of the Revenue Act of 1978. In certain circumstances, Section 530 can relieve businesses of employment tax liability resulting from worker misclassification, but the business must meet specific requirements under the law.

The business must meet the following three requirements to receive relief under Section 530:

• Reporting consistency
• Substantive consistency, and
• Reasonable basis

The business must meet ALL three tests. Meeting these three tests means that the business will not owe employment taxes for the workers in question.

Let's talk about the two consistency tests.

The business must demonstrate two types of consistency:

1. First, the business must treat all workers in similar positions the same. This is called substantive consistency. The business (and any predecessor business) must not have treated the workers, or any similar workers, as employees. If you treated similar workers as employees, this relief provision is not available. In other words, treatment of the workers must be consistent with the position that they were not employees. For example, if the business treated a worker as an independent contractor, it must treat all workers in a similar position as independent contractors. Lets say a business employed 20 workers performing the same duties under the same direction and control, and treated 15 as employees and 5 as independent contractors. In this scenario, the substantive consistency test would not be met.
2. Second, the business must file all required federal tax returns on a consistent basis. This is called reporting consistency. This means that if a business believes a particular worker or group of workers are properly classified as independent contractors, then the business must demonstrate to the IRS that they have been filing the required forms for example, Form 1099-MISC for those independent contractors.

Relief is not available for any year the business did not file the required Forms 1099-MISC. If they filed the required Forms 1099-MISC for some workers, but not for others, relief is only available for the workers for whom the 1099-MISC was filed.

Section 530 - Reasonable Basis

In addition to meeting both consistency tests, the business must also have a reasonable basis for not treating the workers as employees. To establish that you had a reasonable basis for not treating the workers as employees, you can show that:

• You reasonably relied on a court case about federal taxes or a ruling issued to you by the IRS; or
• Your employment tax liabilities were audited by the IRS at a time when you treated similar workers as independent contractors and we did not reclassify those workers as employees; or
• You treated the workers as independent contractors because you knew that was how a significant segment of your industry treated similar workers; or
• You relied on some other reasonable basis. For example, you relied on the written advice of a business lawyer or accountant who knew the facts about your business.

It is the position of the IRS that the judicial precedent relied upon must have been in existence at the time you made the decision to treat the workers as independent contractors. Additionally, if you are relying on industry practice, you will need to show that you knew, at the time you began treating your workers as independent contractors, that this was the industry practice for example, a survey of the industry prior to your treatment.

If you did not have a reasonable basis for treating the workers as independent contractors, you do not meet the relief requirements.

Resources

If you would like more information on worker classification, there are several resources available at www. IRS.gov. These include:

• Publication 1779(PDF)
• Form SS-8(PDF), and
• Publication 1976(PDF), Section 530 Relief Requirements

Just type the words worker classification into the search box.

Section 530 relief requirements: To receive relief, you must meet all three of the following requirements:

I. reasonable Basis

First, you had a reasonable basis for not

treating the workers as employees. To

establish that you had a reasonable basis for

not treating the workers as employees, you

can show that:

You reasonably relied on a court case

about Federal taxes or a ruling issued to

you by the IRS; or

Your business was audited by the IRS

at a time when you treated similar

workers as independent contractors and

the IRS did not reclassify those workers

as employees. You may not rely on

an audit commenced after December

31, 1996, unless such audit included

an examination for employment tax

purposes of whether the individual

involved (or any other individual holding

a substantially similar position) should

be treated as your employee; or

You treated the workers as independent

contractors because you knew that

was how a significant segment of your

industry treated similar workers; or

You relied on some other reasonable

basis. For example, you relied on

the advice of a business lawyer or

accountant who knew the facts about

your business.

If you did not have a reasonable basis

for treating the workers as independent

contractors, you do not meet the relief

requirements.

n

h

II. Substantive Consistency

In addition, you (and any predecessor

business) must have treated the workers,

and any similar workers, as independent

contractors. If you treated similar workers

as employees, this relief provision is not

available. If you are paying an individual

who is providing services as a test proctor or

room supervisor assisting in the administratio

of college entrance or placements

examinations, the substantive consistency

requirement does not apply with respect

to services performed after December 31,

2006, (and remuneration paid with respect

to such services). The provision applies if

the individual (1) is performing the services

for a tax-exempt organization, and (2) is not

otherwise treated as an employee of such

organization for purposes of employment

taxes.

III. reporting Consistency

Finally, you must have filed all required

federal tax returns (including information

returns) consistent with your treatment of eac

worker as not being employees. This means,

for example, that if you treated a worker as

an independent contractor and paid him or

her $600 or more, you must have filed Form

1099-MISC for the worker. Relief is not

available for any year and for any workers

for whom you did not file the required

information returns.

The IRS examiner will answer any questions

you may have about your eligibility for this

relief.

Other sources:

http://www.houstontx.gov/onestop/onestop1.pdf

The danger of mischaracterizing employees as independent contractors is that the employer can be hit with very substantial penalties and additional tax liability.

The IRS is increasing audits to enforce payroll tax obligations. 

Inconsistent treatment of similar workers is harmful evidence.