The IRS Test: Employees and Independent Contractors

Respecting the difference between independent contractors and employees is good for everyone. Employee status, that is, a specifically-defined job for a particular company at a set rate of pay, is good for some. The employer-employee relationship permits the employer to exercise control over the how the employee performs his or her job. In turn, the employee is relieved of the hassles of business ownership and benefits from the employer paying 1/2 of the employee’s Social Security tax (or 6.2%).

In other cases, however, a worker’s ability for function as an independent contractor is critical to the success of the worker and the business owner alike. Independent contractors are just that, independent, and can choose the means and methods by which the job is completed. Are you a night owl? Work better on the weekends? An independent contractor is free to choose the methods by which he or she performs the job, just so long as the job gets done.

Both federal and state governments, however, have an interest in who has what status. The trend among governments is clearly towards labeling as many workers as possible as “employees”. Why? Couple of reasons:

(1) An employer is responsible for withholding taxes from an employee’s salary, and can be subject to up to a 100% fine for failing to do so properly. Having the employer do the work of collecting and paying taxes on the government’s behalf is a lot easier than matching the 1099 an employer provides to a contractor to the 1099 the contractor reports on his or her taxes.

(2) The “success” of government mandates, including workman’s comp, unemployment compensation and the new Health Care legislation, depend heavily on the number of employees a company has. Independent contractors do not receive benefits from their employers, but may be paid at a higher rate to compensate for this. The employer may be willing to pay this premium in order to stay below key thresholds that trigger all kinds of compliance requirements. Pushing as many people as possible into “employee” status, from the government’s perspective, pulls that many more companies into paying for the many different public programs that could not exist if more companies were exempt.

In determining whether the person providing service is an employee or an independent contractor, the government will consider all information that bears on the degree of control and independence must be considered.
Common Law Rules

Facts that provide evidence of the degree of control and independence fall into three categories:

  • Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  • Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  • Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

As of September, 2011, the IRS launched a new program dubbed the “Voluntary Classification Settlement Program”. Under this program taxpayers who previously misclassified as independent contractors individuals over whom the employer has control (i.e. “true” employees) can make the switch with a minimal 10% penalty on the amounts that would otherwise have been withheld and submitted to the government. The employer will face no penalties or interest on these amounts either, and will not be audited as to the employment status of the individuals so classified for prior periods. The program offers considerable benefits for employers who have been using contractors who clearly fit the definition of employees as described above. Ordinarily if the taxpayer is audited and his employees reclassified the employer can be liable for the amounts of tax not previously withheld (that’s right, the TAX), plus interest and penalties for not having remitted these amounts to the government. As such, this program could be a good option.

There are two problems, however. First, a “settlement” program implies that the employer has done something wrong and is given the option to “come clean”. This will apply to some, as noted above. It is certainly designed, however, to sweep into this program employers whose employees may or may not really be independent contractors. There is no “bright line” test for whether an individual is an employee or an independent contractor. It is a balancing, fact-specific test. Many employers whose workers could qualify as independent contractors will participate out of fear of an audit going the other way. In an environment where so many businesses are operating so close to the edge the fear of losing one’s entire business to a tax audit one could argue the government is muscling people when they’re down.

So why the government’s grand interest in everyone being “employees”? Well, follow the money. Employers are the best tax collectors in the world, they have no choice. The employer withholds employees’ taxes for the government, and the penalties for failing to do this are severe. With this responsibility comes no small administrative, accounting and cash flow burden. This is a cost of doing business and has been for many years, however, employers have also traditionally had the freedom to structure their workforce as they saw fit, within reason, and mostly without highly publicized “settlement” opportunities in front of the threat of audit.

Classifying employees also has considerable consequences for other laws and obligations the apply to businesses of certain sizes. These thresholds – or tripwires, depending on your perspective – can sweep an employer into a range of federal laws dealing with discrimination, overtime, medical leave, unemployment and, most recently, health care. There is also a host of state-level laws dealing with many of the same issues, as well as insurance considerations such as workman’s compensation insurance. Certainly there may be good reasons for this type of legislation, and the laws do provide safe harbors for smaller businesses who may not have the resources to comply with all of the regulations.

But that’s the point. An employer looking at expanding, but at the cost of walking into a whole new world of compliance, may simply choose not to do so. This chilling effect undoubtedly aggravates the present unemployment situation and invites a downward spiral of killing the geese that are providing what jobs remain. Capital responds to incentives, and the negative incentives to expansion in the United States are becoming considerable.

It is critical to consult with an experienced tax attorney before considering participating – or not participating – in the newly announced Voluntary Classification Settlement Program. Contact us for your consultation.