EXECUTIVE
SUMMARY |
MANY INDEPENDENT CONTRACTOR
RELATIONSHIPS BEGIN at the
request of the service provider, but this
is no guarantee the IRS will not challenge
the classification. The IRS has final
authority for deciding whether a worker is
an independent contractor or an employee.
THERE ARE A NUMBER OF
BENEFITS TO THE CONTRACTING
party of classifying a worker
as an independent contractor, including
no medical insurance costs, no need to
pay retirement benefits and
recordkeeping and other administrative
cost savings. However, if the IRS later
reclassifies a contractor as an
employee, the employer faces liability
for back payroll taxes, possible
criminal sanctions and invalidation of
benefit plans.
THE BEST PROTECTION CPAs
CAN RECOMMEND TO employers or
clients against having a worker
successfully seek employee status is to
rigorously apply the 20 common-law IRS
guidelines for determining whether a
service provider is an employee or an
independent contractor.
EXERCISING EXCESSIVE
CONTROL OVER A SERVICE
provider’s activities is one
factor the IRS will look at that could
put a contracting party at risk of
reclassification. Even where companies
are following the letter of the law,
CPAs should encourage them to be careful
and keep a sharp eye on court decisions
concerning independent contractor
status.
COMPANIES SHOULD NOT
DEPEND ON THE INDUSTRY
practice safe harbor provisions
to avoid independent contractor
reclassification. Recent legal decisions
point out that even traditional
independent contractors such as golf
caddies can potentially be reclassified
as employees. | MITCHELL L. STUMP, CPA, is a
sole practitioner of Mitchell L. Stump,
CPA, PA, in Palm Beach Gardens, Florida.
He is the author of the Club Tax Book,
which covers the accumulation of tax
issues specific to private clubs. His
e-mail address is
mitch@clubtax.com . HANS SPROHGE,
CPA/ABV, PhD, is professor of accountancy
at Wright State University in Dayton,
Ohio. His e-mail address is hans.sprohge@wright.edu
. |
he IRS is responsible for
determining whether an individual who provides
services to a business is an independent
contractor or an employee. Although many
independent contractor relationships begin at the
request of the service provider, this is no
guarantee the IRS will not challenge the
classification. In some instances the service
provider may later claim employee status,
triggering an IRS audit. This article suggests
some preventive measures CPAs can recommend
employers or clients take to avoid a successful
IRS challenge when an independent contractor seeks
to be reclassified as an employee.
Wrong Label The
GAO estimates that 38% of the employers
the IRS examines have
misclassified workers as independent
contractors. Source: Center for
a Changing Workforce (
www.cfcw.org ) and the GAO ( www.gao.gov
).
|
CONTRACTOR CLASSIFICATION
Some service providers prefer
independent contractor status because of the tax
benefits not available to employees, including
being able to contribute significant dollars to
their own qualified retirement plan and deducting
legitimate business expenses. Whatever the
provider’s reason for wanting to be classified as
an independent contractor, the business remains
the entity the IRS and the courts will go after
for any misclassification. Some of the
obvious tax and financial benefits to the
contracting business of avoiding classifying a
service provider as an employee include
No need to provide medical insurance.
No payments of retirement benefits.
No employee payroll taxes.
Obtaining services at a fixed rate,
no matter what the time required to complete the
assignment.
Employee recordkeeping, clerical and
other administrative cost savings. In
light of these benefits, it is very easy for a
contracting party to give in to the wishes of a
potential service provider who wants to be
classified as an independent contractor.
However, if the worker is successful in having
the IRS reclassify him or her as an employee at
some later date, the contracting party faces
certain risks:
Liability for back payroll taxes,
plus penalties and interest.
Court time and costs for any related
litigation.
Out-of-court settlements to make the
issue go away.
Unwelcome attention and
embarrassment.
Criminal sanctions, including
imprisonment and fines.
Personal liability for corporate
officers of up to 100% of the amount the employer
should have withheld from the employee’s
compensation in payroll taxes.
Invalidation of benefit plans.
POTENTIAL CLAIMS
A service provider the IRS deems
to be an employee can make a variety of claims
against the employer. These include
Overtime pay under the Fair Labor
Standards Act if the hours he or she provided to
the contracting party in the past exceeded the
standard workweek.
Retirement benefits.
Medical coverage for injuries
sustained on the contracting party’s property.
A shift in liability from the service
provider to the contracting party for injuries to
other people or damage to property.
A shift in responsibility for
harassment charges from the service provider to
the contracting party.
Unemployment claims. Service
providers also could sue for the right to have
stock options, participate in profit-sharing plans
and receive disability payments, workers’
compensation and more. Businesses generally will
not face this problem if they have a quality,
ongoing working relationship with their
independent contractors. Assuming both parties are
following independent contractor classification
guidelines, difficulties usually occur only when
the relationship sours and the service provider
feels unduly harmed. When it is the
service provider who seeks reclassification, the
IRS may flag the contracting party for an audit of
how it classifies all of its independent
contractors. If the audit results in the
reclassification of more than one independent
contractor as an employee, the financial
consequences could be ruinous.
RESOURCES
| Book
Tax Strategies for the
Self-Employed. Published by CCH (#
CC005111P0100DJA).
CPE
Independent Contractor or
Employee? A CPE self-study course by CCH
(# CCEMPLYEP0000DJA).
Payroll Taxes and 1099s:
Everything You Need to Know (#
730754JA). For more information
or to place an order, go to
www.cpa2biz.com or call the
Institute at 888-777-7077.
|
A CASE IN POINT
A California State Court of
Appeals decision is a perfect example of how good
things can go bad ( Jerry Ware v.
Workers’ Compensation Appeals Board, Bel-Air
Country Club, no. B129578 WCAB nos. VNO
363324 and VNO 366471; see also Claremont
Country Club v. Industrial Acc. Com.
(1917) 174 Cal. 395). A workers’ compensation
appeals board determined Jerry Ware, a golf
caddie, was an employee of a country club, not an
independent contractor. What went wrong for the
club? Ware claimed he sustained various orthopedic
injuries while the club “employed” him as a
caddie. The caddie testified he had had a
continuous employment relationship with the club
and offered a number of factors to prove his
point, including having to wear special
clothing—including a cap issued by the club—and
the need for him to abide by rules of conduct the
club established. The club also paid him in cash
based on chits signed by the members. Based on
these circumstances, in particular the control the
club exerted over Ware’s dress, behavior, the
services rendered and the payment process, and the
fact his services benefited the club, the court
concluded an employment relationship had been
established and the caddie should be classified as
an employee. Without delving into the merits of
the case, which may have national ramifications,
the point is that given his situation, the caddie
found it more beneficial to be considered an
employee. The industry practice safe
harbor provision under section 530 of the Revenue
Act of 1978 provides businesses with no assurance
the IRS will not reclassify a service provider as
an independent contractor. In the country club
industry, for example, it is common practice to
classify caddies as independent contractors.
However, as the case points out, a caddie was
nevertheless reclassified as an employee. CPAs
should advise companies not to overly rely on
industry practice when classifying workers. They
should consider each case individually and make a
prudent decision.
|
PRACTICAL TIPS TO
REMEMBER
| |
Employers can
avoid the high costs of having
a service provider’s
designation changed from
independent contractor to
employee by vigorously
applying the 20 common-law
factors. When reviewing these
factors, businesses should not
put too much emphasis on those
in its favor and ignore those
that are not.
When classifying
workers, CPAs should encourage
companies to follow the letter
of the law. They should look
carefully at recent court
decisions as the courts seem
anxious to bring service
providers under the employee
umbrella.
Businesses and
workers can use form SS-8 (
www.irs.gov/pub/irs-pdf/fss8.pdf
) to get IRS help in
determining the worker’s
status. The questions on the
form also highlight factors
the IRS considers important in
making this determination.
Companies
shouldn’t overly rely on
industry practices when
classifying workers but
should, instead, consider each
case individually.
| |
SAFEGUARDING AGAINST RECLASSIFICATION
The best protection CPAs can
recommend to employers or clients against the
potentially ruinous costs of changes in
independent contractor status is to rigorously
apply the 20 common-law factors the IRS developed
to help businesses determine whether an individual
is an employee or independent contractor (see
exhibit on page 90). The factors are intended as
guidelines, not as strict rules. The IRS itself
says, “the degree of importance of each factor
varies depending on the occupation and the factual
context in which the services are performed.” The
IRS developed the factors based on relevant cases
and rulings. They focus on the substance of the
arrangement—whether the person for whom the
services are performed exercises sufficient
control to classify the worker as an employee.
For additional guidance CPAs should help the
contracting party review these resources:
Revenue ruling 87-41 and description
of employment status under section 530(d) of the
Revenue Act of 1978.
Sections 31.3121(d)-1, 31.3306(i)-1
and 31,3401(d)-1 of employment tax regulations,
relating to the Federal Insurance Contributions
Act (FICA), the Federal Unemployment Tax Act
(FUTA) and the Collection of Income Tax at Source
on Wages (chapters 21, 23 and 24 of the Internal
Revenue Code).
IRS F orm SS-8, Determination of
Employee Work Status for Purposes of Federal
Employment Taxes and Income Tax Withholding
(
www.irs.gov/pub/irs-pdf/fss8.pdf ).
Businesses and workers file form SS-8 to ask
the IRS to determine a worker’s status for
purposes of federal employment and income tax
withholding. It includes questions that describe
the relationship between the two parties,
including the amount and nature of behavioral and
financial control. While the form itself does not
provide guidance, the questions the IRS poses
offer some insight into factors it considers
important. The IRS will not issue a determination
letter for proposed transactions or hypothetical
situations although it may issue information
letters. When considering the 20
common-law factors, the contracting party should
resist the temptation to focus on those in its
favor and downplay or ignore factors that are not.
If a company designates someone as an independent
contractor when a majority, but not all, of the 20
common-law factors shows he or she is an employee,
it is only asking for trouble. Exercising
excessive control over the activities of a service
provider is one of the factors that will put a
contracting party at risk of reclassification. In
almost every case in which the IRS or the courts
overturn an independent contractor relationship,
it is obvious there are a number of factors
falling into the employee status column. CPAs
should encourage companies to proceed with caution
and keep a sharp eye on the courts. The judicial
trend seems to be to bring the service provider
under the contracting party’s umbrella as an
employee. |