By Kenneth H. Bridges, CPA, PFS March 1996
Companies frequently use contractors in lieu of “employees.” It is an arrangement that works well for both parties. The contractor gets to maintain his or her sense of independence and usually commands a higher hourly rate, 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 invalid.
While the primary risk is on the employer, a reclassification can be detrimental to the independent contractor as well. If the independent contractor has formed a qualified retirement plan, such plan may be invalid if the contractor is determined to be an employee.
The 20 Factor Test
The determination as to whether a worker is an independent contractor or an employee is a very subjective one. However, there are twenty common law factors that the IRS generally looks to in making this determination. Workers are generally considered to be employees if they:
1 – Must comply with employer’s instructions about the work.
2 – Receive training from or at the direction of the employer.
3 – Provide services that are integrated into the business.
4 – Provide services that must be rendered personally.
5 – Hire, supervise, and pay assistants for the employer.
6 – Have a continuing working relationship with the employer.
7 – Must follow set hours of work.
8 – Work full-time for an employer.
9 – Do their work on the employer’s premises.
10 – Must do their work in a sequence set by the employer.
11 – Must submit regular reports to the employer.
12 – Receive payments of regular amounts at set intervals.
13 – Receive payments for business and/or traveling expenses.
14 – Rely on the employer to furnish tools and materials.
15 – Lack a major investment in facilities used to perform the service.
16 – Cannot make a profit or suffer a loss from their services.
17 – Work for one employer at a time.
18 – Do not offer their services to the general public.
19 – Can be fired by the employer.
20 – May quit work at any time without incurring liability.
None of the above factors are controlling, and there is no mathematical weighing of the factors. As stated before, it is a very subjective determination.
Section 530 Safe Harbor Not Available for Some Technical Personnel
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.
Unfortunately, however, the rules were changed in 1986 to provide that the safe harbor would no longer be available for 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.