Independent Contractor or Employee?

Many workers who are treated as independent contractors are actually employees.  There has been a flux on the part of the Internal Revenue Service to watch these types of relationships more closely in recent years.  The cost to improperly classify an employee as an independent contractor can be devastating to an employer.  This article addresses the various issues an employer should weigh in deciding how to treat an individual who is working for him, and some of the more frequently asked questions we receive on this topic.

Why is there such a fuss over whether I classify someone as an independent contractor and let them pay there own social security taxes?

If the IRS ever audits you and reclassifies one of your workers as an employee, you will be held liable for all the employment taxes that should have been withheld from the worker's pay.  Employment tax includes a worker's state and federal income tax withholding, not just their FICA tax.  So now you not only owe what you should have paid in as your share of the FICA taxes and the state and federal unemployment taxes, you are also liable for everything that should have been withheld from the employee and submitted to the various taxing authorities.  You are also liable for penalties and interest for failure to pay these taxes and for failure to file payroll tax returns, if that applies as well.  The employer may receive some credit against the liability to the extent the employer can obtain evidence that the worker had already paid the tax. When an audit covers three years, the proof can be hard to obtain. The employer is not allowed to recover the assessed tax from the worker.

Another possible undesirable outcome is that you may have a retirement plan retroactively disqualified which could cause all vested accrued benefits to become fully taxable for all employees enrolled in the plan.  You would have some pretty upset employees on your hands along with a tax bill and interest and penalty charges to pay.

So the fuss is definitely warranted. Employers should exercise extreme caution in making these determinations.  Seeking the advice from a qualified professional is well advised whenever an employer has questions concerning the status of a person working for him.  

I have several people who come in and do specialized work on a job site.  How do I decide if they should be treated as an employee?

The term employee must be distinguished from an independent contractor for purposes of employment tax obligations.  A common law employee status is determined by applying common law factors to each individual case to verify if an employer/employee relationship exists. If the person for whom the worker performs services has the legal right to control and direct the worker, an employer/employee relationship exists. [IRC §3121(d)(2)] (Rev. Rul. 87-41]  An employer does not generally have to withhold taxes on payments to independent contractors.  In addition to the common law definition that focuses on the control that is exercised over what work is done and how it is done, the IRS will use a list of 20 factors to determine whether an individual should be treated as an independent contractor.

Revenue Ruling 87-41 (known as the common law rules) has a set of 20 factors used to determine if a worker is an employee or an independent contractor.  A more recently published IRS training manual changed the focus of Revenue Ruling 87-41 by reorganizing the 20 factors into the following groups:

Group 1: Behavior Control Factor. An employer has the right to control how an employee does the work. An independent contractor usually retains control over how the work is done.

       Group One factors that indicate employee status include:

• Instructions: a worker who is required to follow instructions about when, where and   how to work, such as the need for prior approval before proceeding with a job.
• Services: must be rendered personally by the worker
• Training: provided to perform a job in a particular manner (other than orientation and safety training).

Group 2: Financial Control Factor. An employer has the right to control how the business aspects of an employee's activities are conducted.  An independent contractor has the right to control his or her own business activities.

        Group 2 common law factors that indicate employee status include:

• Realization of a profit or loss: Worker does not realize a profit or suffer a loss as a result of services performed (other than agreed upon compensation for work performed).
• Significant investment: Worker depends on the employer to provide the facilities, tools, equipment and materials needed to perform a particular job.  The worker is generally reimbursed for business and travel expenses incurred.
• Services available to public: Worker does not work for more than one company at a time and does not make his or her services available to the general public.
• Manner of payment: Worker is either paid by the hour or is on a salary,  an independent contractor is usually paid by the job or receives a commission.

Group 3: Relationship Factor. These factors illustrate how the worker and the business perceive their relationship with one another.  For instance, is there a written contract for a temporary period of time or does the worker receive benefits from the employer or are his services an integral part of the business' operations.

    Group three common law factors include:

•  Written contract: (not included in the original 20 factors) the contract must have substance (method of payment, handling of expenses, how work is done) designating the worker and an independent  contractor.
• Employee benefits: (not included in the original 20 factors) health insurance, pension plans, vacation and sick pay benefits are only paid to employees.
• Continuing relationships: a temporary relationship is more likely to indicate independent contractor status even if it is long term.
• Integration: if the worker's services are an integral part of the business operations, the worker is generally an employee.

Group 4: Less Important Factors.

This group of common law factors is now considered less important than those in the first three groups and is of a more procedural nature.  They include:

• Employer's right to discharge the worker.
• Worker's right to terminate the relationship.
•  Part- or full-time work requirement.
• Setting hours to do the work.
• Setting of an order or sequence of the work.
• Interim oral or written reports requirements.

Other items included in the IRS training manual:

• Incorporated workers generally will not be re-characterized as employees.
• W-2s do not necessarily indicate employee status.
•  State law or any other government or industry-imposed regulation is not a relevant  factor.

Can you give me some real life instances where these factors were applied?  This is really confusing to me.

Sure, the following cases may be helpful to your understanding of the application of these factors.  Keep in mind that what is decided in one case cannot necessarily be interpreted to mean the same ruling for another similar case.  You may have a completely different ruling based on the individual circumstances and facts of each situation.

Case #1: The court found that carpet installers who contracted with a flooring services firm to provide installation services were independent contractors. Issues that weighed in favor of independent contractor status were:

• Installers determined the sequence, manner and skill with which jobs were completed.
• Control over the installers was maintained only to the extent necessary to have a ready and able work force.
• Installers held the risk of profit or loss on their jobs.
• Installers hired and controlled their own “helper” work force.
• Installers negotiated prices for jobs, turned jobs down and worked without penalty for other carpet installation companies.
• Installers owned and used their own tools and supplies.

(Consolidated Flooring Services v. U.S ., KTC 1997 305)

Case #2: A CPA was hired for 20 hours per week to assume the duties of a comptroller who had recently resigned. The court concluded that the CPA was an independent contractor for the following reasons (Young s, TC Memo 1995-94):

• Employer was only interested in the results and did not control the details of the work.
• CPA performed some of the work on employer's premise and some at his home where he did work for other clients as well.
• Although paid by the hour, CPA was hired on job-by-job basis.
• Court did not view the work relationship as permanent.
• Although there was no written contract for each job, the court did not think either party would have terminated the relationship in the middle of a project.
• CPA's activities were not an integral part of the business because services were of a type usually performed by outside parties.

What about a household worker that comes into my home on a regular basis?  Do I have to treat them as an employee or contractor?

If you have someone who comes into your home on a regular basis, say weekly from somewhere like Merry Maids or a similar service, you would not have to worry about anything because they control how the work is done. Service agencies such as Merry Maids, usually have set standards and policies that their workers must follow on how to do the tasks they are assigned.  However, if you hire an individual on your own to come in and clean or provide other services, you do need to make an employee versus independent contractor determination. 

Employee status is determined without regard for whether the work is full or part time, what work is done, how the worker is paid, or whether the worker was obtained through an agency.  If the worker controls how the work gets done, and when it gets done, then he/she is an independent contractor.  If, however, the homeowner controls these, then the individual is an employee. 

My friend has household employees that he does not have to pay any employment taxes for.  How can this be, given the rules?   How do I go about paying the employment taxes for my household employees?

The rules for household workers are somewhat different.  If you determine that the worker is an employee, then you as an employer must withhold and pay FICA tax on wages of $1,300 or more per year per employee.  No FICA taxes are withheld if wages paid in the calendar year are less than $1,300.  FICA tax must be withheld and paid on all of the employee's wages if the wages are $1,300 or more in the calendar year (including the first $1,300 of wages paid).  For example, an employer paid a maid $800 and a babysitter $600 during 2001.  No FICA taxes are due because each employee received less than $1,300 during the year.  If the household employee is under the age of 18 at any time during the year, no FICA taxes are due for that individual if the job is not their principal occupation.  If a minor is a full-time student, they are deemed to have an occupation.

Household employers also must pay FUTA tax on FUTA wages paid of $1,000 or more per quarter (in the current or preceding year) per employer.  FUTA wages are the first $7,000 of wages paid to each household employee in the calendar year.  Example:  Assume the combined wages of $1,400 in the above example were paid in a single quarter.  The employer is liable for FUTA tax.  You then owe FUTA on all wages for the entire calendar year and on all of the next year's wages as well whether or not they go over the $1,000 floor.  Unemployment taxes are imposed by most states as well, although each state's rules vary from each other and from the federal rules.  You may owe unemployment in your state for any household employees but not federal unemployment.  If you do not pay state unemployment taxes that are due in a timely manner, federal unemployment taxes (FUTA) are raised.  Household employers must file Schedule H with their 1040 to pay FICA, FUTA and any withheld federal income taxes.  Household employment taxes are paid in through an employer's estimated tax payments during the year.

I am self-employed and I pay estimated tax payments on a regular basis.  How do I report what I owe for employment taxes and withholding for my employees?

Self–employed taxpayers who have a business or farm operated for profit have two options for reporting employment tax withholding.  They can use Form 940 and 941 (or 943 ) for all employees, business and household, or they can file Forms 940 and 941 for business employees and Form 1040 Schedule H for any household employees.

I recently earned my real estate license and my new boss told me that they do not have to withhold anything from my pay.  Is this true?  And what do I have to do?

Your new boss is correct.  You are considered a non-employee by law.   The technical terminology is a statutory non-employee.  Qualified Real Estate Agents must be licensed and paid on a commission basis, and a contract must exist stating that the agent will not be an employee for federal tax purposes.   In fact, any person who sells consumer products outside a permanent retail establishment and is paid on a commission basis, and a contract exists that states the salesperson will not be an employee for federal tax purposes is a statutory non-employee.  This also includes newspaper carriers.  These people receive a 1099 and file a Schedule C and SE and pay in their FICA and federal tax throughout the year through estimated tax payments.

I have a friend who sells life insurance and gets a W-2.  Is this correct?

The Internal Revenue Code lists four occupational groups that are not employees under the Common Law Rules but are considered employees under the Statutory Rules for FICA purposes.  They are: 1) Agent Drivers or Commission Drivers- limited to workers who distribute meat, vegetables, fruit, bakery, beverage (other than milk) products or laundry/dry cleaning services;

2) Full-time Life Insurance Salespersons for one company;  3) Home-workers who work for one employer making clothing, craft, needlecrafts, bedspreads, buttons, quilts, gloves, etc;  and, 4) Traveling/City Salespersons who sell for one principal employer. 

If you are a statutory employee, your employer does not have to withhold any federal income tax from your pay, but they will withhold FICA and are responsible for their share of your FICA.  You will receive a W-2 each year with the box marked on it showing that you are a statutory employee.  In the case of a statutory employee, you would want to file a schedule C and check the box on that schedule for the statutory employee status.  This allows you to deduct your business expenses there, avoiding the 2% of AGI floor on Schedule A  You should discuss this with a tax professional to decide the best route for your situation. 

What can I do to protect myself as a business owner from having the IRS come in and find me at fault?

Businesses should have a worker sign a written agreement attesting to the fact that he/she is an independent contractor.  It is also a good idea to have the worker bill the business for services rendered and provide their own tools, supplies, training, transportation, etc.  As much independence as possible should be given to the worker in areas such as hours worked, supervision on the job and the location where the work is performed. 

If you are unsure how to classify a particular worker you can have the IRS make the determination for you by filing a Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the District Director of the Internal Revenue Service in your area. 

For employers who have trouble convincing the IRS that a worker is an independent contractor under the Common Law or Statutory Employee/Nonemployee rules, the business may use Section 530 of the Revenue Act of 1978.  Under this act a business is entitled to treat a worker as an independent contractor for employment tax purposes of all if the following conditions are met:

1. Reasonable basis for not treating the worker as an employee
2. The Business has not treated the worker or others performing substantially similar work as employees after 12/31/77, and
3. The business has reported amounts paid to the worker on a timely filed Form 1099.

Are there other agencies I should worry about besides the IRS, when dealing with this issue?

Yes, improperly treating an employee as an independent contractor can cause you grief, not only with the IRS, but also with Job Service for unemployment claims or with your worker's compensation insurance carrier for not properly including them on your worker's compensation insurance policy.  If you do not have worker's comp insurance and someone you have claimed as independent establishes that he/she was an employee, you could have enormous liability.  You would need to seek legal advice in this instance. 

Since these issues are so important to the vitality of your business, we again highly recommend that you seek professional advice whenever you are faced with these difficult decisions in classifying workers as employees or independent contractors.

©2006 by Dierking Lockie & Associates PC
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