By Kenneth H. Bridges, CPA, PFS June 2023
Companies frequently use contractors in lieu of “employees.” It is an arrangement that can work well for both parties. The contractor gets to maintain his or her sense of independence, usually commands a higher hourly rate, can maintain his or her own retirement plan, and can deduct out of pocket business expenses, while the company for whom the work is performed avoids withholding and payroll taxes, does not have to include the contractor in its benefit plans, and avoids the sense of longer-term commitment that may come with an “employee.” The IRS, however, sometimes disagrees with the classification and challenges that an “independent contractor” is in fact an “employee.” This article explores the consequences to both parties of a reclassification by the IRS, lists the factors used by the IRS in making this determination, and addresses how you can best protect yourself from being stung by this issue.
Consequences to “Employer” and “Employee” of Misclassification
If a worker is properly classified as an independent contractor, then the company for whom the services are provided is not required to withhold taxes, pay payroll taxes, nor include the worker in its benefit plans. However, if the IRS determines that an independent contractor should have been classified as an employee, then the employer may be liable for the taxes that should have been withheld and paid, and the employer’s benefit plans may be found to be noncompliant.
While the primary risk is on the employer, a reclassification can be detrimental to the independent contractor as well. If the independent contractor has made contributions to a retirement plan, such contributions may be subject to disallowance if the contractor is determined to be an employee. Further, business expenses which the contractor may have claimed as deductions on Schedule C would not be tax deductible as an employee.
The 20-Factor Test and the 3-Factor Test
The determination as to whether a worker is an independent contractor or an employee is a very subjective one. For many years, there were twenty common law factors that the IRS generally looked to in making this determination. Workers were generally considered to be employees if they:
- – Must comply with employer’s instructions about the work.
- – Receive training from or at the direction of the employer.
- – Provide services that are integrated into the business.
- – Provide services that must be rendered personally.
- – Hire, supervise, and pay assistants for the employer.
- – Have a continuing working relationship with the employer.
- – Must follow set hours of work.
- – Work full-time for an employer.
- – Do their work on the employer’s premises.
- – Must do their work in a sequence set by the employer.
- – Must submit regular reports to the employer.
- – Receive payments of regular amounts at set intervals.
- – Receive payments for business and/or traveling expenses.
- – Rely on the employer to furnish tools and materials.
- – Lack a major investment in facilities used to perform the service.
- – Cannot make a profit or suffer a loss from their services.
- – Work for one employer at a time.
- – Do not offer their services to the general public.
- – Can be fired by the employer.
- – May quit work at any time without incurring liability.
None of the above factors were considered controlling, and there is no mathematical weighing of the factors. As stated before, it is a very subjective determination.
While the 20 factors above are still relevant, in more recent years the focus of IRS has shifted to 3 factors: behavioral control, financial control and relationship; which largely encompass the 20 factors listed above.
Behavioral control – The IRS is likely to consider a worker to be an employee if the business has the right to direct and control the work performed by the worker, provides detailed instructions on when and where to work, what tools to us or where to purchase supplies and services, has evaluation systems to measure the details of how the work is done, and/or provides on-going training as to how to do the work.
Financial control – Employees are generally guaranteed a regular wage (plus possibly bonuses and commissions), whereas independent contractors are more often paid a flat fee for the job. Also, independent contractors typically have an investment in the equipment they use for the job, have an opportunity for profit or loss, and make their services available to others.
Relationship – The type of relationship depends on how the worker and the business perceive their interaction with each other. Although a contract stating that a worker is an independent contractor is not binding on the IRS, a written contract which describes the relationship between the parties is important evidence. The provision of benefits like insurance, retirement plan and vacation pay or sick pay is indicative of an employer/employee relationship, as is an expectation of permanency in the relationship. Also, the degree to which the services of the worker are a part of the services provided by the business are important in the determination.
Section 530 Safe Harbor
In 1978, Congress enacted Section 530, which provided a safe harbor for companies with respect to their treatment of a particular worker as an independent contractor, if the company: 1) did not treat the individual as an employee for any period; 2) filed all tax returns (including Forms 1099) on a basis consistent with its tax position; and, 3) had a “reasonable basis” for treating the worker as an independent contractor. “Reasonable basis” was defined to include having a case or ruling that supports the taxpayer’s position, a previous IRS audit in which the independent contractor treatment resulted in no assessment, or a long-standing industry practice.
The rules were changed in 1986 to provide that the safe harbor would no longer be available for companies which provided third parties with engineers, designers, drafters, computer programmers, systems analysts, or other similarly skilled workers. Such workers must satisfy the common law test to avoid classification as employees for employment tax purposes.
Some believe that they can get around the issue by having the worker form his or her own corporation. While this may be a factor in favor of independent contractor treatment, it is not bullet-proof. In fact, the Conference Report to the 1986 Act provided that the IRS could look through such structures to the substance of the relationship.
Steps That Can Be Taken to Reduce Exposure
When in doubt about the appropriate classification of a worker, generally the safest route is to treat the worker as an employee. However, if the worker is to be treated as an independent contractor, then the parties should be certain to sign a written agreement evidencing their understanding that the worker is to be treated as an independent contractor and will be responsible for his or her own taxes. Sometimes it is not the IRS that is the company’s worst enemy, but rather a disgruntled worker. So-called “independent contractors” have been known to later claim that they were in fact an employee and ask the “employer” for a W-2 reflecting withheld taxes.
The payor should be certain to issue a Form 1099 to any independent contractors. If an employer filed Forms 1099 with respect to misclassified workers, then the employer’s tax liability for prior periods is generally limited to its share of the FICA taxes, plus 20% of the employee’s share of the FICA taxes, plus 1.5% of wages for income tax withholding.
The IRS is very concerned that employers are misclassifying employees as independent contractors. A reclassification of workers by the IRS can be very costly to both the “employer” and the “employee.” Both parties should be aware of the rules and the potential consequences. In situations where there is doubt, it is probably best to treat the worker as an employee. If the worker will be treated as an independent contractor, then a written agreement should be executed and the payor should be certain to issue a Form 1099.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.