Back to basics: Classifying workers as independent contractors or employees can be tricky

How do taxpayers know if they’re self-employed? Often, it comes down to employee versus independent contractor classification.

By: Catherine Martin  /  August 26, 2019

Classifying workers is an important component of any business that hires workers, and it can have a substantial impact on taxes. This issue also affects all job types. Even professional wrestlers are suing, unionizing, and otherwise vying for reclassification as employees instead of independent contractors (who are treated as self-employed). They highlight this common problem for businesses and those who perform duties for them.

The California Assembly, in particular, has taken up this issue by passing the AB-5 Worker status bill. If the California Senate also passes the bill, workers in California such as wrestlers, Uber, Lyft, and Amazon drivers, and even manicurists and exotic dancers may be automatically classified as employees instead of independent contractors if they meet the three conditions laid out in the bill.

For the wrestlers with notoriously strict employment contracts, reclassification as employees would qualify them for a whole host of benefits under important laws, such as the Family and Medical Leave Act (FMLA) and Fair Labor Standards Act (FLSA). Not to mention that their employer would then be responsible for paying Social Security and Medicare taxes. An employer that misclassifies an employee as an independent contractor without reasonable justification will be liable for these unpaid taxes and potential penalties.

IRS Voluntary Classification Settlement Program allows for relief from misclassification

There is also a voluntary program through the IRS that allows a business to reclassify its workers as employees with partial relief from paying federal employment taxes. The Voluntary Classification Settlement Program (VCSP) authorizes eligible taxpayers to apply for relief from the full amount of employment tax liability that would have been due, the interest and any penalties on the amount, and an employment tax audit with respect to worker classification.

The taxpayer must apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP).

For taxpayers already under examination by the IRS, they may be eligible for the Classification Settlement Program, which is very similar to the VCSP.

Independent contractor definitions for classifying workers

So, what exactly do these worker classifications mean? Here are some definitions to help.

Independent Contractor – most simply defined, an independent contractor exists when the worker is only subject to the control and direction of another as to the results of the work, not the means. The worker controls how the work is completed, where the results is subject to approval by another.

Employee –most simply defined as a worker whose employer can control both the results of the work as well as the means.

Statutory Employee – A worker that by the facts and circumstances would be classified as an independent contractor but has been specified by statute as an employee.

These workers fall into one of four categories:

  • Drivers whom are agents of the employee or whom are paid on commission whom also distribute meat, vegetables, fruit, bakery products, or beverages (except milk), or who pick up and deliver laundry/dry cleaning.
  • Life insurance sales agents (full time) whose principal business activity is selling life insurance or other annuity contracts (or both), usually for one life insurance company.
  • An individual worker who completes work the employer specifies from his or her home, while the employer supplies the materials or goods, and the work must be returned to the employer or to an employer-named person.
  • A full-time salesperson (traveling or not) who works on behalf of the employer, turns in orders to the employer, the goods of which must be sold as merchandise or supplies in the buyer’s business. The work is the salesperson’s principal business activity. The buyers are typically wholesalers, retailers, contractors, operators of hotels, restaurants or other similar establishments.

In addition, for statutory employees, Social Security and Medicare taxes must be withheld if they fit three conditions:

  • The service contract states or implies that substantially all the services are to be performed personally by them.
  • They do not have a substantial investment in the equipment and property used to perform the services (other than in transportation facilities).
  • The services are performed on a continuing basis for the same payer.

Statutory Nonemployee – These are employees treated as self-employed by statute for all Federal tax purposes, including income and employment taxes. There are three categories of statutory nonemployees; direct sellers, licensed real estate agents, and certain companion sitters. Companion sitters who are not employees of a placement service are generally treated as self-employed. Direct sellers/licensed real estate agents are treated as self-employed if:

  • Substantially all payment for services are directly related to sales or other output, rather than to number of hours worked.
  • Services are performed under a written contract providing they will not be treated as employees for Federal tax purposes.

Tax rules and forms for independent contractors

The business/employer may be required to give any independent contractor it pays a Form 1099-MISC, Miscellaneous Income, to report what has been paid. Independent contractors must pay their own income tax and self-employment tax, as the business does not withhold taxes from workers’ pay. An independent contractor may need to make estimated tax payments during the year to avoid end-of-year tax liability.

Self-employed independent contractors report their business income and deduct business expenses on Schedule C (Form 1040), Profit or Loss From Business.

Tax rules and forms for employees

The employer will withhold income tax and the employee’s portion of Social Security and Medicare taxes from wages. The employer is also responsible for paying Social Security, Medicare, and FUTA taxes on wages paid to employees. The Form W-2, Wage and Tax Statement, will report to employees what was withheld from their pay.

Determining whether a worker is classified as an independent contractor or an employee is a question of fact

Traditionally, this can be a confusing area of law, especially for new business owners with no prior experience making the determination. The IRS utilizes a 20-factor test as the main guideline to determine whether workers should be classified as independent contractors or traditional employees. No one factor determines the worker’s classification; rather, it is a weighing of the factors and circumstances in which the worker and the employer’s dynamics play out.

The factors split into three categories, each representing an area of worker/employer professional relations. These categories are behavioral control, financial control, and the relationship of the parties.

Behavioral control category factors

This category includes the factors that show if an employer retains the right to direct and control how the worker does the work.

The IRS factors that fall under the behavioral control category are as follows:

  • Instructions to worker
  • Training
  • Requirement that services be rendered personally
  • Setting the hours of work
  • Requirement of full time work
  • Working on employer premises
  • Setting the order or sequence of work
  • Requiring oral or written reports
  • Furnishing worker’s tools and materials
  • Working for more than one business at a time
  • Availability of worker’s services to the general public

Financial control category factors

These are the facts that shows whether the employer has the right to control the economic aspects of the worker’s job.

The IRS factors that fall under the financial control category are as follows:

  • Hiring, supervising, and paying assistants
  • Paying worker by the hour, week, or month
  • Payment of worker’s business and/or traveling expenses
  • Significant investment by worker
  • Realization of profit or loss by worker

Relationship of the parties category factors

These facts establish the type of relationship the employer and worker believed they were entering. This goes to the belief of both parties, written contracts, employee benefits, and who decides whether the relationship will continue.

The IRS factors that fall under the relationship category are as follows:

  • Integration into business operations
  • Continuity of the relationship (permanency)
  • Firms’ right to discharge worker
  • Worker’s right to terminate relationship

There are a few slightly different factors that are considered by Bankruptcy Court, Tax Court, as well as common law principles that have been created by other court cases over the years.

Bankruptcy Court uses its own factors

The Bankruptcy Court has stated that the IRS factors are not comprehensive and included additional factors to be considered. The most notable addition is taking into account the custom and industry practices as well as the benefit situation of the workers.

Other factors include:

  • The industry practice or custom in the area
  • The intent of the parties
  • Whether written, signed independent contractor agreements were executed
  • Whether employee-type benefits were provided (paid vacation, sick leave, medical insurance, pension accrual)

Tax Court factors view the degree of control as the most influential

The Tax Court has its own factors, but it views the degree of control as the most influential in their decision-making process. This factor refers to the “right” to control, not necessarily whether control is actually exercised.

Other factors include:

  • Degree of control exercised by the employer
  • Which party invests in the work facilities used by the worker
  • The worker’s opportunity for profit or loss
  • Whether the employer can discharge the worker
  • Whether the work is part of the employer’s regular business
  • The permanency of the relationship
  • The method of payment
  • Whether the work required special skills
  • The relationship the parties believed they were creating

Common law principles

Other common law principles are also pervasive throughout most jurisdictions. These principles also can overlap with other previously listed factors.

Common law principles include:

  • Degree of control exercised by the principal (employee) over the details of the work
  • Which party invested in the facilities used in the work
  • The individual’s opportunity for profit or loss
  • Whether or not the principal had the right to discharge the individual
  • Whether the work was part of the principal’s regular business
  • The permanency of the relationship
  • The relationship the parties believed they were creating

Worker classification has a drastic effect on the relationship between the business and its workers, the economic opportunity for the workers, the financial health of the employer, and sets the course for both the future of the business and those who work for it. For these reasons, ensuring accurate worker classification as either an employee or an independent contractor is an essential first step for any business.

 

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Catherine Martin

Catherine Martin, JD, is a senior tax research analyst at The Tax Institute. Catherine works with a team of tax attorneys and CPAs who review and analyze legislation and the impact of tax laws on taxpayers.

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