Independent Contractor/Employee Classification
By: Robert T. Leonard, J.D., C.P.A.
Generally, it is economically beneficial for employers to treat workers as independent contractors. The additional costs for treatment of a worker as an employee include:
- Increased payroll tax costs:
- FICA – 12.4% of $62,700.
- Medicare – 2.9% of gross wages without limitation.
- FUTA – 6.2% of $7,000.
- Pension plan participation.
- Health insurance, worker’s compensation, and other benefit costs.
- Labor laws.
B. Recharacterization of Employee Status for Federal Employment Tax Purposes.
Tests for Determining Employee Status – Statutory Employees.
Although there are various differences in the definitions of an “employee” for income tax withholding, FICA and FUTA, the determination of “employee” status is generally the same under each statute.
Employees may be either “statutory” employees or “common law” employees. Statutory employees include corporate officers, certain drivers, and certain sales personnel. Other workers are generally considered employees if they meet the “common law” employee definition.
Common Law Employees.
Generally, a worker is considered a common law employee if the person for whom services are performed has the right to control and direct the worker performing the service, not only as to the result to be accomplished, but also as to the details and means by which the result is accomplished. In 1987, the IRS issued Revenue Ruling 87-41, 1987-1 C.B. 298, summarizing the law and containing a non-exclusive list of 20 common law factors to be considered, including whether:
- The employer instructs the worker on how to complete the task.
- The employer trains the worker.
- The services of the worker are integrated into the employer’s business.
- The worker renders the services personally.
- The worker has the right to hire, fire, supervise, or pay assistants.
- There is a continuing relationship between the worker and the employer.
- There are set hours of work.
- Full-time work is required.
- The worker is required to perform their services on the premises of the employer.
- The worker sets the order or sequence of work completion.
- The worker reports orally or in writing to the employer.
- The worker is paid an hourly, weekly, or monthly salary.
- The employer pays the worker’s business and/or travel expenses.
- The employer furnishes the worker’s tools or materials.
- The worker does not have a significant investment in tools or machinery.
- The worker has the potential to realize a significant profit or loss.
- The worker does not work for others simultaneously.
- The worker does not make their services available to the general public.
- The employer has the right to discharge the worker.
- The worker has the right to terminate the relationship.
- Section 530 – Safe Harbor.
Due to the lack of certainty in this area, Congress created a “safe harbor” within which workers could be treated as independent contractors without fear of reclassification by the IRS. Section 530 of the Revenue Act of 1978 was initially intended to be a temporary provision that would apply for a limited period of time. However, permanent legislation was not enacted and § 530 was extended indefinitely.
If the requirements of § 530 are satisfied, the worker is treated as an independent contractor and will not be reclassified by the IRS as an employee for employment tax purposes.
Safe Harbor Requirements.
- Reporting Consistency: All federal tax returns (including information returns) required to be filed by the employer with respect to the workers must have been filed on a basis consistent with the employer’s treatment of the workers as independent contractors, rather than employees.
- Substantive Consistency: The employer must have consistently treated similarly-situated workers as independent contractors. If a similarly-situated worker was treated as an employee, § 530 relief is not available.
- Reasonable Basis: The employer must have had some reasonable basis for treating the workers as independent contractors, rather than employees. A reasonable basis includes reliance on:
- Precedent: Judicial precedent, published rulings, technical advice or letter rulings issued to the employer.
- Prior Audit: In a prior audit of the employer, no worker in a substantially similar position was reclassified by the IRS as an employee. The prior audit relied upon need not by an employment tax audit.
- Long-Standing Custom of the Industry: A significant segment of the industry traditionally treated similarly-situated workers as independent contractors. The term “industry” has been broadly defined in favor of the taxpayer.
- Any Other Reasonable Basis: The foregoing list is not exclusive, and any other reasonable basis will suffice, such as lack of control over the workers.
- Classification Settlement Program.
- On March 5, 1996, on a special two-year basis, the IRS implemented a Classification Settlement Program (“CSP”) providing for an expedited resolution of the worker classification issue.
- Under CSP, a series of graduated settlement offers are available, including:
- If the employer satisfies the § 530 Reporting Consistency requirement, but either clearly does not satisfy the § 530 Reasonable Basis test, the settlement offer would be a full employment tax assessment for one taxable year, with the employment tax liabilities computed under § 3509, if applicable. In such event, the employer must agree to properly classify its workers as employees on a prospective basis, ensuring future compliance.
- If the employer satisfied the Reporting Consistency requirement and has a colorable argument that it meets the Substantive Consistency requirement and the Reasonable Basis test, the offer would be an assessment of 25% of the employment tax liability for one taxable year, computed using § 3509, if applicable. In such event, the employer must agree to properly classify its workers as employees on a prospective basis, ensuring future compliance.
- If the employer clearly satisfies the Reporting and Substantive Consistency requirements and satisfies the Reasonable Basis test, the requirements of § 530 are satisfied and no assessment will occur. The employer may choose to continue treating its workers as independent contractors. In such event, the employer must agree to properly classify its workers as employees on a prospective basis, ensuring future compliance.
- Interest-Free Adjustment; Revenue Ruling 75-464; § 6205.
In the event of a recharacterization of workers as employees from independent contractors, if the employer agrees to the recharacterization with either the Examination Division or the Appellate Division of the IRS (following a timely Protest), and the additional FICA tax is paid in full before the date the current Form 941 would be due for the quarter within which there is an agreement with the IRS as to the recharacterization, no interest will be due on the additional liability arising as a result of the recharacterization.
C. Recharacterization of Employee Status for California Employment Tax Purposes.
Complete list of EDD’s 14 factors
Even though the EDD only uses eight of the IRS’ 20 factors, the key thing a hiring firm must prove to either agency is that it had no right to control the work or the worker. Therefore, the other 12 IRS factors still can be used to prove (or disprove) this. Here are the EDD’s factors:
Control: The most important factor is whether the hiring firm has the right to control the manner and means of accomplishing a result. The right to fire at will, without cause, is strong evidence of the right to control.
The EDD has ruled that the right to control must be “complete, authoritative, entire, absolute, supreme, full, unqualified or of a similar character.”
The following factors are considered only if the courts cannot determine if the hiring firm had the right to control the worker:
- Distinct occupation or business: Independent contractors usually are engaged in a separately established occupation or business.
- Industry practices: The courts consider whether in the particular locality the kind of work involved is usually done as an employee, under the direction of the hiring firm, or as an independent contractor, a specialist working without supervision.
- Skill required: Independent contractors typically have specific skills for their particular occupation.
- Own tools: Independent contractors usually supply their own instrumentalities, tools and place of work.
- Not a continuing relationship: The courts consider the length of time the contractor was hired to work.
- Payment timing: Independent contractors should be paid by the job, not by the hour or month.
- Work not essential to hiring firm: Independent contractors should not do work that is part of the hiring firm’s regular business.
- Belief of parties: The court takes into consideration whether both parties believe they have created an independent contractor/hiring firm relationship.
- Actual control: The court evaluates the extent of actual control that the hiring firm exercised over the manner and means of the worker’s services.
- Hiring party is in business: The court takes into consideration whether the person who ordered the work was in business. If so, the worker is more likely to be an employee.
- Additional factors
The factors also have been used in legal cases to support court decisions.
- Own work hours: Independent contractors should set their own work hours.
- Time to pursue other work: Usually, independent contractors do not work full-time for one person.
- Job location: Independent contractors should not be required to perform work in a specific area or over a fixed route.
- Services don’t have to be rendered personally: Independent contractors should be above to delegate their work.