Employee status vs. independent contractor: Tax strategies and traps for the unwary

Misclassification of employment is a major problem for both employers and employees that can be costly whether it is deliberate or unintentional. For a variety of reasons, employers seek to have workers classified as independent contractors rather than employees. The perceived benefits from such a classification include no payroll taxes and fringe benefits, no unemployment or workers’ compensation expenses, no minimum wage requirement, no labor unions and, in general, greater work force flexibility and lower cost. As a result of these perceived advantages, many employers may take the calculated risk of classifying workers as independent contractors if their status is not clear-cut. In general, enforcement by the IRS is lax so employers generally feel they can avoid being questioned on the classification. Furthermore, if an employer is audited, it can defend the classification in a variety of ways, some of which are described here in this article, in order to have penalties mitigated for misclassification.

Proceed with caution

The IRS is more vigorously pursuing cases of misclassification as the number of workers classified as independent contractors increases.  In 2010, the IRS implemented a three-year research program of 6,000 random employment audits focusing on worker classification. In addition, during the Obama Administration, the IRS Chief of Employment elevated worker classification cases to a major IRS focus. Despite the recent change in presidential administration, it is unlikely that assertive pursuit of employment misclassification by the IRS will go away, although it could be diminished.

Identifying your employees vs. contractors

The status of one of your workers, if examined, will be analyzed under a common-law test and under statutory standards.  The IRS applies a three-part common-law test in determining employment status that evolved from a 1987 Revenue Ruling.4 In that ruling, 20 factors were delineated that help guide IRS agents in determining status. These factors are detailed on IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. These 20 factors are synthesized into three categories involving behavioral control, financial control and the relationship of the parties.

The characteristics of behavioral control include determination of work methods, requirements for specific job training or instruction, required reports, location where the work is performed and hiring and paying work helpers. Financial control involves responsibility for work assets, expense reimbursement, workers’ compensation, type of pay and who bears financial risk. The relationship of the parties is established by such conditions as the payment of fringe benefits, who can terminate the relationship, union membership, advertising, business cards, and whether similar services are provided by the worker to other entities.

All three conditions need not be consistently met in an IRS agent’s determination of worker status. In addition, actual control need not be present to find an employment relationship. It is the right to control that determines the employment relationship. The IRS and the courts look to the overall body of evidence in making a determination.

Uber: A perfect example

Uber is an example of a company that illustrates the problematic nature of the common-law employment test. Most Uber drivers reportedly value the independent nature of the work. They merely flip on their app and they are “working.” In addition, the driver provides the car and pays all maintenance expenses. However, Uber sets the price for rides, including “surge” pricing, and, even more importantly, can terminate the relationship for poor ratings.

Two recent court cases, in Massachusetts and California, confirmed the drivers’ independent contractor status; however, the company agreed to provide greater transparency regarding driver ratings and to specify conditions for deactivating drivers. In addition, the company agreed to pay 385,000 drivers $84 million ($218 per driver). As with other independent contractor disputes, the courts will have the final say in applying the common law rules that decide these conflicts.

Penalties can be severe for misclassification

If an employer makes a misclassification error (even if unintended) in determining worker status, the penalties can be substantial. If there is “intentional disregard” (e.g., off-the-books transactions) in deducting and withholding federal taxes, employers are responsible for all unreported taxes for all years under examination. This includes federal income tax with marginal rates as high as 39.6%, employer and employee shares of FICA taxes, and federal unemployment compensation taxes. In addition penalties for missed deposits (10%) and withholdings (20%) are assessed. These penalties are intended for cases of “intentional disregard,” so it is more likely that a company making an error in classification would face the reduced penalties, resulting from negligence as opposed to fraud, under Section 3509.

In addition, the worker has to be aware of taxpayer liability for employer misclassification.  While the employer is subject to penalties for the misclassification, this does not absolve the taxpayer from his or her income tax obligation.

Solutions to complex situations

Most worker classification situations are routine and without contention. Some, however, are nebulous and require a thorough understanding of tax laws and regulations on the part of employers to avoid costly penalties and interest. This is especially true today now that the IRS has increased its scrutiny of worker classification.   To preempt disputes, either the firm or the worker can file Form SS-8 to get a binding determination of worker status from the IRS. In most cases, it is the worker who desires the ruling to qualify as an “employee.”

While most work classification situations are not overly complicated, having the advice of a tax expert can make these conversations and decisions pain free.  Please contact a tax expert at Caroprese & Company for more information.

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