David Lerner Associates:Worker Classification and Taxes
How you classify a worker – as an independent contractor or an employee – will affect how much you pay in taxes, whether you need to withhold from your workers’ paychecks and what tax documents you need to file. Here are some things to keep in mind when classifying your workers:
If the IRS is successful in reclassifying a worker as an employee the employer:
Becomes liable for employment taxes that should have been withheld from the worker's pay, such as FICA, federal, and state income taxes
• Becomes liable for the employer's share of FICA taxes
• Becomes liable for state and federal unemployment taxes
• Becomes liable for penalties and interest for failure to pay these taxes and for failure to file payroll tax returns
• May have its retirement plan retroactively disqualified, which could cause all vested accrued benefits to become fully taxable for all employees enrolled in the plan
The employer may receive some credit against the liability to the extent the employer can obtain evidence that the worker has already paid the tax that the employer should have withheld. When an audit covers three years, such proof of payment can be hard to obtain. The employer is not allowed to recover the assessed tax from the worker. If the worker already paid self-employment tax as an independent contractor, the worker may be entitled to a refund. The refund is limited to the excess amount of taxes paid as an independent contractor over the amount that should have been paid as an employee.
Common Law Rules
Revenue Ruling 87-41 includes a set of 20 factors derived from the common law that the IRS uses to help determine if a worker is an employee or an independent contractor for federal tax purposes. None of these factors is conclusive, and the factors may be weighed differently, depending on the facts and circumstances. In an internal manual used for the training of its own employees, the IRS has classified these factors into three primary groups and a fourth group of generally less important factors.
Group 1–Behavior control factor
An employer generally has the right to control how an employee does the work. In contrast, an independent contractor usually retains control over how the work is done. The following factors tend to indicate employee status:
• Instructions: A worker who is required to follow instructions about when, where, and how to work or who needs prior approval before proceeding with a job
• Services must be rendered personally by the worker
• Training: Provided to perform a job in a particular manner (other than orientation and safety training)
Group 2–Financial control factor
An employer generally has the right to control how the business aspects of an employee's activities are conducted. In contrast, an independent contractor generally has the right to control his or her own business activities. The following factors tend to indicate employee status:
• Opportunity for profit or loss: Worker does not have the opportunity to realize a profit or suffer a loss as a result of services performed (other than agreed upon compensation for work performed)
• Significant investment: Worker depends on the employer to provide the facilities, tools, equipment, and materials needed to perform a particular job
• Unreimbursed expenses: The worker is generally reimbursed for business and travel expenses incurred
• Services available to public: Worker does not work for more than one company at a time and does not make his or her services available to the general public
• Method of payment: Worker is either paid by the hour or is on a salary (An independent contractor is usually paid by the job or receives a commission, although employees may also receive commissions.)
Group 3–Type of relationship
The following factors tend to illustrate how the worker and the business perceive their relationship:
• Intent of the parties: A written agreement between the parties in which they agree to treat the worker as an employee tends to show the intent of the parties to create an employer/employee relationship. In order to be of evidentiary value, the agreement must do more than label the relationship. It also must set forth the substance of the relationship (such as method of payment, handling of expenses, how work is done, etc.) in a manner consistent with the label chosen
• Employee benefits: The provision of health insurance, pension plans, and vacation and sick pay benefits tends to indicate that the recipients of such benefits are employees
• Continuing relationship: A temporary relationship is more likely to indicate independent contractor status, even if it is long term
• Integration: If the worker's services are an integral part of the business operations, this tends to indicate that the worker is an employee.
Group 4–Less important factors
The following common law factors are now considered less important than those in the first three groups:
• Employer's right to discharge the worker
• Worker's right to terminate the relationship
• Part-time or full-time work requirement
• Work required to be done on employer's premises
• Setting of hours to do the work
• Setting of an order or sequence of the work
• Interim oral or written reports requirement
Other items included in the IRS training manual
• Incorporated workers (for example, professional corporations) generally will not be recharacterized as employees (although in certain circumstances, the corporate entity may be disregarded)
• The filing of W-2s with respect to a worker tends to indicate the parties' belief that the worker is an employee, but this inference can be rebutted
• State laws or determinations of federal or state agencies characterizing workers as employees for purposes of various benefits should be disregarded in determining the federal tax treatment of a worker
Occupational groups
The Internal Revenue Code sets forth certain groups of workers that are treated as employees for FICA, FUTA, and/or federal income tax withholding purposes, regardless of their status under the common law factors.
Employees defined by law
Corporate Officer: A corporate officer is generally treated as an employee for FICA, FUTA, and federal income tax withholding purposes. An officer is an employee for these purposes even if he or she is the sole shareholder and has control of his or her own duties and remuneration.
A corporate officer who performs only minor services or no services is not an employee if he or she is not entitled to receive, directly or indirectly, any payment.
Common Law Employee: Common law employees are treated as employees for FICA, FUTA, and federal income tax withholding purposes. As noted, a worker's common law status is determined by weighing the common law factors applicable to the individual facts and circumstances of the relationship to determine if an employer/employee relationship exists. If the person for whom the worker performs services has the legal right to control and direct the worker, generally, such a relationship is treated as existing for federal tax purposes.
Statutory Employee: The Internal Revenue Code lists four occupational groups that are treated as employees for FICA purposes, even if they would not have qualified as employees under the common law:
• Agent Drivers or Commission Drivers: Limited to workers who distribute meat, vegetables, fruit, bakery products, or beverages (other than milk), or laundry/dry-cleaning services. These drivers are also treated as employees for FUTA purposes.
• Full-Time Life Insurance Salespersons: Salespersons who solicit contracts primarily for one company.
• Homeworkers: Workers who work at home for one employer making clothing, needlecrafts, bedding, etc. Also may apply to workers providing typing or transcribing services.
• Traveling/City Salespersons: Sell full-time for a single business. These salespersons are also treated as employees for FUTA purposes.
Nonemployees defined by law
Corporate Directors: A director is not treated as an employee of a corporation for FICA purposes if the director is acting in his or her capacity as a director.
Statutory Nonemployees:
• Qualified Real Estate Agent: Not treated as an employee for federal tax purposes if licensed and paid on a commission basis, and a written contract exists between the agent and the business stating that the agent will not be treated as an employee for federal tax purposes
• Direct Seller: Not treated as an employee for federal tax purposes if the salesperson sells consumer products outside a permanent retail establishment, is paid on a commission basis, and a written contract exists between the salesperson and the business stating the salesperson will not be an employee for federal tax purposes
• Companion Sitter: Sitters (for children, the elderly, or the disabled) are not treated as employees of a placement agency if the agency does not receive the salary or wages of the sitter, and the agency is compensated by the sitter or the persons who employ the sitter on a fee basis
Section 530
If the business has trouble convincing the IRS that a worker is an independent contractor under the Common Law Rules or the Statutory Employee/Nonemployee Rules, the business may take advantage of Section 530 of the Revenue Act of 1978, which provides relief from the employer's tax liability resulting from an IRS reclassification of a worker from independent contractor to employee status. (Section 530 does not impact the employee's liability for FICA, FUTA, and federal income tax. Section 530 is not part of the Internal Revenue Code.)
Section 530 requirements
Under Section 530, a business is entitled to treat a worker as an independent contractor for employment tax purposes if all the following conditions are met:
• The business has a reasonable basis for not treating the worker as an employee
• The business has not treated the worker or others performing substantially similar work as employees for any period
• The business has reported amounts paid to the worker on one or more timely filed Form(s) 1099
Section 530 standards for not treating a worker as an employee
Section 530 includes tests for determining whether a business has a reasonable basis for not treating the worker as an employee. Among the factors that show a reasonable basis are the following:
• Judicial precedents, published rulings, or determination letters from the IRS that may relate to that particular business situation.
• Prior IRS audit of the business that was concluded without any assessment attributable to the business's treatment for employment tax purposes of workers similar to the worker now in question.
• Business can rely on the long-standing recognized practice of a significant segment of its industry. The practice does not have to be the same throughout the entire industry.
Section 530 rules
• Employers can rely on a past audit history only if the audit included an examination for employment tax purposes of whether the worker (or a worker in a similar position) was properly classified.
• Ten years is treated as a safe harbor, however, the IRS cannot require a fixed length of time for a particular industry but instead must consider the facts and circumstances.
• Twenty five percent of an industry constitutes a significant segment of an industry. (However, a lower percentage may be treated as significant, depending on the facts and circumstances.)
• If the employer makes a prima facie case to establish that it was reasonable not to treat a worker as an employee and it cooperates with IRS requests for information, the IRS bears the burden of proving the employer was wrong in its classification of workers.
• An employer can reclassify a worker as an employee and begin to pay employment taxes without impacting its right to Section 530 relief with respect to its classification of workers as independent contractors for prior years.
• Section 530 is not considered a relief provision that applies only to workers who are employees under the common law rules. Employers can seek relief under Section 530 while maintaining that the workers in question are independent contractors for other purposes.
• The IRS is required to notify the employer of its rights under Section 530 as soon as a worker classification issue is raised in an audit.
Examples of IRS determinations of independent contractor status
Newspaper carriers
Individuals engaged in distributing newspapers are classified as direct sellers and treated as independent contractors for federal income and employment tax purposes. The carriers' remuneration must be directly related to sales or output rather than based on an hourly wage. A written contract must exist stating that the individual is an independent contractor for employment tax purposes.
Registered representative of a securities broker-dealer
Generally, the fact that a worker is required to comply with instructions is treated as an indication of employment status. However, in determining the employment status of a registered representative of a broker-dealer for federal tax purposes, no weight is to be given to instructions from the broker-dealer regarding investor protection standards required by federal or state agencies.
Worker classification settlement program (CSP)
Under the worker classification settlement program (CSP), the IRS has established procedures that allow an employer to settle a worker classification dispute without going through an administrative appeal or a judicial review. If an IRS auditor determines that an employer has misclassified a worker as an independent contractor under the common law, the auditor must determine whether the employer qualifies for Section 530 relief.
Settlement offer
The degree to which the requirements of Section 530 are met determines the type of settlement offer. If the employer consistently filed all required information returns that treated the class of workers as independent contractors but (1) clearly has not consistently treated the class of workers as independent contractors or (2) clearly does not have a reasonable basis for treating the class of workers as independent contractors, the IRS offer to settle will be a full employment tax assessment for the one taxable year under examination (as opposed to opening up other years for examination and possible assessment).
If the employer consistently filed all required information returns in a manner treating the class of workers as independent contractors and has (1) a "colorable argument" as to consistently treating the class of workers as independent contractors and has a (2) "colorable argument" as to having a reasonable basis for treating the class of workers as independent contractors, the IRS offer to settle will be an assessment of 25 percent of the employment tax liability for the audit year. In the aforementioned situations, the employer must agree to begin treating the class of workers as employees for all current and future periods.
If the auditor determines the employer clearly meets all Section 530 requirements, no assessment will be made, and the employer can continue treating the class of workers as independent contractors. If more than one class of workers is being examined, any offers under the CSP program will apply to each class separately.
Voluntary classification settlement program (VCSP)
Under the new voluntary worker classification settlement program (VCSP), the IRS has established procedures that allow an eligible employer to voluntarily reclassify workers as employees for federal employment tax purposes and obtain relief similar to that obtained in the classification settlement program (CSP) outside of the examination context.
Eligible employers
To be eligible, an employer must
• Consistently have treated the workers as nonemployees
• Have filed all required Forms 1099 for the workers for the pevious three years
• Not currently be under audit by the IRS
• Not currently be under audit by the Department of Labor or a state agency concerning worker classification
• Have complied with the results of any previous audit by the IRS or the Department of Labor concerning worker classification.
Effect of the VCSP
By participating in a VCSP, you agree to prospectively treat the class of workers as employees for future tax periods. You are required to pay 10 percent of the employment tax liability that may have been due on the workers' compensation for the most recent tax year, but you will not be liable for any interest or penalty on the liability, or subject to an employment tax audit concerning worker classification for prior years. In addition, you agree to extend the statute of limitations for assessment of employment taxes by three years for each of the three years beginning after the date set in the VCSP for treating the workers as employees.
Application for the VCSP
If you wish to participate in the VCSP, you submit Form 8592, Application for Voluntary Classification Settlement Program, along with the name of a contact person or an authorized representative with a power of attorney (Form 2848), at least 60 days before you want to begin treating the workers as employees. The IRS retains discretion whether to accept the application for the VCSP. If accepted, you enter into a closing agreement with the IRS and pay any amount due under the closing agreement.
Strategies for business owners seeking to classify their workers and independent contractors
1.Written agreement
Businesses should have a worker sign a written agreement attesting to the fact that he or she is an independent contractor.
2. Worker independence
As much independence as possible should be given to the worker in areas such as hours worked, supervision on the job, and the location where the work is to be performed. In addition, to the extent possible, the worker should be required to provide his or her own tools, supplies, training, transportation, etc.
Taxpayers who do not know how to classify a particular worker can get the IRS to make the determination by filing Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with their District Director of Internal Revenue.
Employees incorrectly treated as independent contractors
Employees who are incorrectly treated as independent contractors by their employers should not use Schedule SE. The earnings are not subject to the employer's half of FICA tax. Instead of Schedule SE, modify Form 4137, Social Security and Medicare Tax on Unreported Tip Income, by substituting "wages" where "cash and charge tips" are shown on line 1 and disregarding line 4. At the top of the form, cross out word "Tip" and replace with "Wages." Workers who feel that they have been misclassified should file Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will answer with a written ruling that outlines the above procedure for filing Form 4137.
Statutory employee expenses
Statutory employees receive special treatment for deducting unreimbursed business expenses. Statutory employees who qualify under IRC Sec. 3121(d)(3) can use Schedule C to deduct their expenses instead of Schedule A.
Business expenses reported on Schedule C are not subject to the 2 percent AGI limitation on miscellaneous itemized deductions.
Procedures for statutory employees not treated as employees under common law
• The compensation of a statutory employee must be reported on a Form W-2 (not a Form 1099-MISC).
• Employer pays one-half of FICA, and the other half is withheld from the employee's wage. (Schedule SE is not filed with Schedule C.)
• No federal income tax is withheld from the employee's wages (assuming that the statutory employee would not otherwise qualify as an employee under common law).
• Statutory employee box must be checked on Schedule C and on the employee's W-2.
• Gross income listed on the W-2 is entered on line 1 of Schedule C (not on the wage line of Form 1040). Any related business expenses are deducted on Schedule C. The net income (loss) is carried to Form 1040.
If the statutory employee also had self-employment income from other sources, this income must be reported on a separate Schedule C and SE.
IMPORTANT DISCLOSURES
Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable– we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
Some of this material has been provided by Broadridge Investor Communications Solutions, Inc.
David Lerner Associates does not provide tax or legal advice. The information presented here is not specific to any individual's personal circumstances.
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