Employee vs Independent Contractor: How misidentifying a worker’s status can lead to considerable tax issues
The question of whether a worker is an independent contractor or employee is one which is of major concern to businesses and various taxing agencies. The consequences of classifying a worker incorrectly creates significant consequences for the business and its owners including responsibility for income tax and FICA/Medicare withholding, matching FICA/Medicare contributions, payment of unemployment tax premiums, worker compensation insurance, pension plan contributions, health care coverage and other costs associated with employees. For owners, the failure to withhold on wages paid to employees can create personal liability if an owner is found to be a “responsible person” of the business. Responsible person assessments are non-dischargeable in bankruptcy and collection relief may be limited as well by the respective taxing authority.
There are also possible consequences to the employee. In that regard, the determination of a worker’s classification impacts their ability to claim the deduction for Qualified Business Income under IRC §199A which is only available to independent contractors.
Given the obligations imposed on employers vis-à-vis employees, businesses often prefer to treat individuals as independent contractors while the various taxing authorities have a marked preference for employee status. As a result, the classification of individuals performing services as independent contractors is constantly under scrutiny, and often the subject of controversy between the taxing authorities, the business and the worker in question.
Given the importance and potential consequences of misclassification it is important for businesses and practitioners to understand how to properly classify workers. At the outset, it is important to note that each set of laws that are impacted by a worker classification determination likely has a different set of rules to determine whether a worker is an employee or independent contractor. For example, the FICA statute provides for common law employees, statutory employees, and statutory non-employees. Those same categories are different for income tax withholding. Therefore, it is important to understand the law in question before attempting to determine the proper worker classification.
In addition, merely calling a worker an independent contractor, or providing a worker with a contract titled “independent contractor”, does not make that worker an independent contractor. While each law has its own methods for worker classification, the general principal applied is whether the business has the right to control and direct the individual who performs the service in question. In this regard, control refers not only to the result to be accomplished by the work, but also the means and details by which that result is accomplished.
In reviewing an employee’s classifications, the taxing agencies generally look at the “twenty factor” common law test. These factors are listed in IRS Revenue Ruling 87-41, and include training, set hours of work, full time required, right to discharge, order or sequence set, right to terminate, continuing relationship, and more.
During a worker classification interview, the taxing authority may interview the business, the workers and any documentation that sheds light on the relationship between the parties. Taxing authorities require employers to maintain all records of each person employed for three (3) or four (4) years depending on the taxing authority in question. While the maintenance of such records is not required with independent contractors since payments to independent contractors do not create payroll tax obligations, it is best for the employer to keep any and all records documenting the relationship to help avoid any tax issues.
If an employer does misclassify their workers as independent contractors, they do have various avenues of recourse to minimize their potential exposure. Such areas include federal and state voluntary disclosures and Section 530 Relief. At the Federal level, a business that believes it has misclassified worker(s) as independent contractors can use the Voluntary Classification Settlement Program (VCSP) to reclassify such worker(s) as employees. Businesses that are eligible and choose to participate in the VCSP promise to treat such workers as employees going forward and in return, the IRS charges minimal back taxes with no interest, imposes no penalties and promises not to open an employment tax audit with respect to the worker classification of those workers reclassified as part of the VCSP submission. In conjunction with a VCSP submission, it is generally recommended that a business consider a state voluntary disclosure such as the New York State Voluntary Disclosure Program. Under the NYS Voluntary Disclosure Program, eligible businesses that wish to reclassify such workers can do so without penalties. In addition, the disclosure period is likely only three years, but in certain situations it could be six years.
Businesses that do not wish to prophylactically reclassify workers, can use Section 530 relief if audited by the IRS. Section 530 relief provides a “safe harbor” to businesses, permitting them to treat individuals performing labor on their behalf as independent contractors rather than as an employee for employment tax purposes, even if the individuals performing labor are technically employees under the common law. Under § 530, a taxpayer can treat an individual as an independent contractor for employment tax purposes if: (1) the taxpayer doesn't treat the individual as an employee for any period; (2) the taxpayer doesn't treat any other individual holding a substantially similar position as an employee for any period; (3) the taxpayer files all required federal tax returns on a basis consistent with treating the individual as a nonemployee; and (4) the taxpayer has a reasonable basis for not treating the individual as an employee. A reasonable basis can be shown if the taxpayer reasonably relies on any one of the following:
(A) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;
(B) a past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or,
(C) long-standing recognized practice of a significant segment of the industry in which such individual was engaged.
(D) other reasonable basis (catch-all)
Section 530 relief does not apply at the State level without specific legislation stating so. For example, New York has not adopted Section 530 relief.