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Nicholas Fiore Nicholas Fiore

Employee or independent contractor?

Misclassifying workers can result in significant liability.

September 26, 2013
by Nicholas Fiore, J.D.

In our current economy, more and more businesses are using freelancers and consultants, rather than hiring new employees.

While this practice is prevalent among companies both large and small, the companies and the workers may not be aware of the actual status of these workers for tax purposes and of the consequences if the workers are improperly classified. It is critical that business owners correctly determine whether the people providing services are employees or independent contractors, since this determination has ramifications for the company, the worker, and the federal government. Because the federal government believes that many of these freelancers and consultants should properly be classified as employees, it is especially interested in examining these relationships and making sure that workers are categorized in the proper manner (especially if that will result in increased tax revenue).

Generally, a business must withhold income taxes, withhold and pay Federal Insurance Contributions Act (FICA) taxes (employer and employee portions of Social Security and Medicare taxes), and pay Federal Unemployment Tax Act (FUTA) taxes on wages paid to all of its employees. In addition, employees may be eligible for other benefits, such as health care or paid time off, and may also be eligible for pensions or other retirement benefits. Those workers acting as independent contractors are generally responsible for paying their own Self-Employment Contributions Act taxes (which equal the combined employer and employee portions of FICA tax) and often are not eligible for these additional benefits. (On the other hand, the self-employed have more favorable tax treatment than employees in a number of tax areas, such as the treatment of business expenses, which this article does not address.)

Determining the correct status of individuals providing services

A person performing services may be a common law employee, an independent contractor, a statutory employee, or a statutory nonemployee. In determining whether the person providing services is an employee or an independent contractor, control is the key concept.

Common law rules

In Rev. Rul. 87-41, the IRS developed a 20-factor test for determining a worker’s status. The IRS grouped these factors into three general categories:

  1. Behavioral control. Does the company control (or have the right to control) what the worker does and how he or she does the job?
  2. Financial control. Are the business aspects of the worker’s job controlled by the payer? These include things like how a worker is paid, whether expenses are reimbursed, who provides tools or supplies, and the workplace, etc.
  3. Relationships of the parties. Are there written contracts between the parties? Does the worker get benefits typically associated with an employer-employee relationship (i.e., pension plans, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the employer’s business?

Businesses must consider the factors in each of these categories when determining a worker's status. Some factors may indicate that the worker is an employee, while others may lean toward independent contractor status. Often, courts examine and weigh all factors to determine the correct treatment. No one factor or number of factors positively determines a worker’s status one way or the other. Also, the factors may depend on the field in which the worker is employed; factors relevant to one worker may not be relevant to another.

The keys in determining a worker’s status and defending the treatment if the IRS challenges it are to (1) look at the entire relationship surrounding the worker, (2) consider the degree or extent of the right to direct and control the worker, and (3) document each of the factors used in the determination.

Form SS-8

If it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status. (Note: It can take at least six months to get an IRS determination after filing Form SS-8. Therefore, a business that often hires the same types of workers to perform specific services may want to consider filing Form SS-8 early on to determine their status.)

Statutory employees

Sec. 3121 includes certain categories of workers who are considered statutory employees. These include corporate officers; certain state and local government employees; drivers who distribute beverages (other than milk) or meat, vegetables, fruits, or bakery products, or laundry or dry cleaning delivery services, and who are paid as agents on commission; individuals who work at home on materials and goods supplied by the business and which must be returned to the business; full-time life insurance salespersons; and traveling salespersons.

Statutory independent contractors

Under Sec. 3508, real estate agents and direct sellers are considered statutory independent contractors.

Misclassification of employees

Consequences of treating an employee as an independent contractor

If an employee is classified as an independent contractor and there is no reasonable basis for doing so, the business may be held liable for employment taxes for that worker and will not be eligible for any (otherwise available) relief.

Relief provisions

Under Section 530 of the Revenue Act of 1978, P.L. 95-600, a company may be relieved of having to pay employment taxes for an independent contractor who has been misclassified. In general, to qualify for this relief, the business must file all required federal information returns (i.e., Forms 1099-MISC, Miscellaneous Income) consistent with its treatment of that worker (the reporting consistency requirement, which means that to qualify, a company must have filed From 1099-MISC for the worker consistent with its claim that the worker was not an employee). The company must also have treated all workers in substantially similar positions as independent contractors (the substantive consistency requirement). And the company must have relied on some reasonable basis (such as a prior IRS exam, published ruling, judicial precedent, or long-standing recognized industry practice) for treating its workers as independent contractors.

Misclassified workers can file Social Security tax forms

Workers who believe they have been improperly classified as independent contractors by an employer can use Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation. The form is filed with the worker’s Form 1040, U.S. Individual Income Tax Return.

Voluntary Classification Settlement Program

In Announcement 2011-64 (modified by Announcements 2012-45 and 2012-46), the IRS set up the Voluntary Classification Settlement Program (VCSP), an optional program that provides businesses with an opportunity to reclassify workers as employees (with reduced federal employment tax liability for past misclassification), for those eligible businesses that agree to prospectively treat their workers (or a class or group of workers) as employees. This program enables worker classification issues to be resolved before the IRS is involved and significantly reduces the burden on taxpayers.

To participate in this program, the business must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.

Eligibility

The VCSP applies to those that currently treat their workers (or a class or group of workers) as independent contractors or other nonemployees, and that wish to treat these workers as employees prospectively.

A company must have consistently treated the workers as independent contractors or other nonemployees and must have filed all required Forms 1099 for them for the previous three years. Additionally, the company cannot currently be under an IRS employment tax audit or involved in a worker classification audit by the U.S. Department of Labor (DOL) or a state agency.

If the IRS or the DOL has previously conducted a worker classification audit, the company will be eligible only if it has complied with the results of that audit and is not currently contesting the classification in court.

VCSP agreements

A company participating in the VCSP must agree to treat the class or classes of workers as employees for future tax periods. In exchange, the company will:

  • Pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Sec. 3509(a);
  • Not be liable for any interest and penalties on the amount; and
  • Not be subject to an employment tax audit for the worker classification of the workers being reclassified under the VCSP for prior years.

Applying for the VCSP

To participate in the VCSP, a company must submit Form 8952. The application should be filed at least 60 days before the date the business wants to begin treating its workers as employees. Businesses accepted into the VCSP will enter into a closing agreement with the IRS to finalize the terms and pay the full amounts due when entering the agreement.

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Nicholas Fiore, J.D., is an attorney with more than 30 years of tax editing and writing experience, primarily with The Tax Adviser. He has worked on the Uniform CPA Examination, wrote and edited both tax and nontax continuing education courses, and has provided tax and business information for a variety of audiences.