Independent Contractor or Not?

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.

Common-Law Factors Indicating Employee Status

1. Instructions. A worker who must comply with other persons’ instructions about when, where and how he or she is to work is ordinarily an employee. This factor is present when the person for whom the services are performed has the right to require compliance.

2. Training. Requiring an experienced employee to work with the worker, corresponding with the worker, requiring the worker to attend meetings or using other training methods indicates the person for whom the services are performed wants them done in a particular method or manner.

3. Integration. Integrating the worker’s services into the business operations generally shows that he or she is subject to direction and control. When the success or continuation of a business depends to an appreciable degree on the performance of certain services, the workers who do them must necessarily be subject to a certain amount of control by the business owner.

4. Services rendered personally. If the worker must render the services personally, presumably the person for whom they are performed is interested in the methods used to accomplish the work as well as in the results.

5. Hiring, supervising and paying assistants. If the person for whom the services are performed hires, supervises and pays assistants, that generally shows control over the workers on the job. However, if one worker hires, supervises and pays the other assistants under a contract in which the worker agrees to provide materials and labor and is responsible only for attaining a result, this indicates independent contractor status.

6. Continuing relationship. A continuing relationship between the worker and the person for whom the services are performed indicates an employer-employee relationship exists. This may occur when work is performed at frequently recurring although irregular intervals.

7. Set hours of work. If the person for whom the services are performed establishes set work hours, this indicates control.

8. Full-time required. If the worker must devote himself or herself substantially full-time to the business of the person for whom the services are performed, the latter has control over the amount of time the worker spends working and implicitly restricts the worker from doing other gainful work. An independent contractor, on the other hand, is free to work when and for whom he or she chooses.

9. Doing work on employer’s premises. If the individual performs the work on the premises of the person for whom the services are performed, this suggests control over the worker, especially if the work could be done elsewhere. Work done off the premises, such as at the worker’s office, indicates some freedom from control. However, this fact by itself does not mean the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the premises. Control over the place of work is indicated when the person for whom the services are performed has the right to compel the worker to travel a designated route, to canvass a territory within a certain time frame or work at specific places.

10. Order or sequence set. If a worker must perform services in the order or sequence set by the person for whom the services are performed, that factor shows the worker is not free to follow his or her own pattern of work but must follow the established routines and schedules of the employer. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set it infrequently. Retaining the right to do so is sufficient to show control.

11. Oral or written reports. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a certain degree of control.

12. Payment by hour, week or month. Payment by one of these three methods generally points to an employer-employee relationship, provided this method is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission basis generally indicates the worker is an independent contractor.

13. Payment of business or travel expenses. If the person for whom the services are performed generally pays the worker’s business and travel expenses, he or she is ordinarily an employee. To control expenses, an employer usually retains the right to regulate and direct the worker’s business activities.

14. Tools and materials. The fact the person for whom the services are performed furnishes significant tools, materials and other equipment tends to show the existence of an employer-employee relationship.

15. Significant investment. If the worker invests in facilities not typically maintained by employees (such as an office rented at fair value from an unrelated party) and uses them to perform services, that tends to indicate the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person for whom the services are performed for such facilities. Accordingly, an employer-employee relationship exists.

16. Realization of profit or loss. A worker who can realize a profit or suffer a loss as a result of his or her services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor. The worker who cannot is an employee. For example, if a worker is subject to a real risk of economic loss due to a significant investment or a bona fide liability for expenses, such as salary payments to unrelated employees, that indicates the worker is an independent contractor. The risk a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus is not sufficient to support independent contractor treatment.

17. Working for more than one entity. If a worker performs more than de minimis services for multiple unrelated persons or companies at the same time, that factor generally indicates the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each, especially where the two are connected.

18. Making service available to the general public. The fact a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.

19. Right to discharge. The right to fire a worker is a factor indicating the worker is an employee and the person with the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer’s instructions. An independent contractor, on the other hand, cannot be fired so long as he or she produces a result that meets the agreed contract specifications.

20. Right to terminate. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time without incurring liability, this indicates an employer-employee relationship.

Independent Contractor or Not?

Companies should beware of service-provider-initiated classification changes.

Get your clients ready for tax season

Black CPA Centennial, 1921–2021