Employee or Independent Contractor

Langdon Owen
February 10, 2009 — 1,671 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

Reclassification of employees can create devastating tax liabilities, major employee benefit problems, and other collateral consequences.  Care in making a proper classification for various purposes is very important.

  • a. Why Classification Makes a Big Difference. Businesses need peo­ple to perform work for them, but how the worker is classi­fied, or reclassi­fied, could make a dramatic monetary difference to the business.
  • i. Tax and Benefit Matters. If the worker is deemed to be an independent contractor for all purposes, the business is not liable for the 7.65% FICA (Social Security and Medicare) tax and the 6.2% FUTA (unemployment) tax which apply to employees. No withholding of state or federal income tax or the employee's share of FICA tax would be required, saving administra­tive burdens and costs. The state law requirement of providing workers compensation insurance may be eliminated. Also, the worker would generally not be entitled to employee benefits of various kinds such as retirement plans, health insurance, vacation, and other fringe benefits. The Employee Retirement Income Security Act of 1974 (ERISA; 29 USC § 1001 et seq.) protects employees, not independent contractors. These possible savings have led some businesses to be aggressive in classifying workers as independent contractors. The tax savings and reductions in worker benefits have also led the Internal Revenue Service and state regulators to be aggressive in the opposite direction of classifying workers as employees. The gray areas of the law have thus led to a number of conflicts.
  • ii. Other Labor Law Matters. The Fair Labor Standards Act (FLSA) requires minimum and overtime wages for certain employees but does not apply to independent contractors. State wage and hour laws and workers compensation laws apply to employees only. Antidiscrimination rules apply to employees under Title VII of the Civil Rights Act, the Age Discrimination in Employment Act (ADEA) and the Americans with Disabilities Act (ADA). The National Labor Relations Act (NLRA) protects employees= rights to organize for collective bargaining. The protections of the Family and Medical Leave Act (FMLA) apply to employees only. On the other hand, independent contractors generally have better protection for their works under the Copyright Act.
  • b. Adverse Results of Reclassification. Some of the conflicts over worker classification have proven very costly to businesses.
  • i. Tax and Benefit Matters. If a worker is reclassified by the Service from independent contractor to employee, the business could be required to pay the income tax that was not withheld, the business's share of FICA taxes that the business did not pay and the employee's share which the business did not withhold, the FUTA tax that was not paid, interest, and a number of penalties. If a significant group of workers are reclassified, the business could become insolvent.
  • (1) The penalties include penalties for failure to pay or withhold tax and failure to file information returns. The principal civil penalties include: Internal Revenue Code ([email protected]) '' 6651(a) (late filing return, failure to pay tax), 6656 (failure to deposit employment taxes), 6662 (negligent or inten­tional disregard of rules or substantial understatement), and 6663 (fraud). In addition, criminal penalties could apply in some situations.
  • (2) The principals of the business could be held personally liable for the failure to withhold and pay what are sometimes called the Atrust [email protected] taxes: income tax withholding and the employee's portion of FICA tax. IRC ' 6672. Others may be liable under IRC ' 6701 for aiding and abetting an understatement of tax liability.
  • (3) If workers are misclassified it could have the effect of disqualifying qualified pension or profit sharing plans. If a worker who is really an independent contractor is wrongly included in a plan as an employee, this could affect its qualified status; also, if a worker who is really an employee is excluded from a plan as an independent contractor, the plan may fail to qualify, for example, by failing to meet the minimum participation standards of IRC ' 410.
  • (4) The results of a dispute involving a reclassification of workers in the gray areas of the law can be truly awful. The gray area is very large indeed, and involves complex and confusing rules. It is too easy for a business which is trying in good faith to comply with the law to either make an error or to act properly but nevertheless be forced into an expensive defense of its position.
  • ii. Other Labor Law Matters. If a worker is misclassified as an independent contractor under the FLSA, the employer may be liable for minimum and overtime wages, liquidated damages in an equal amount, and further penalties for severe or willful violations. Similarly, misclassification under other employment-related laws will often change dramatically the rules and protections applicable to the parties.
  • iii. Collateral Matters. Some industries, such as health care, have regulatory regimes which treat certain rules as applying or as not applying depending on whether a person is an employee or not. For example, full or part time physicians treated as common law employees for purposes of Federal Insurance Contributions Act (Social Security) taxes (26 USC ' 3121(d)(2), may qualifying for certain exceptions to referral prohibitions under federal law which use the standards of 26 USC ' 3121 (d)(2) as the basis for its definition of employee. If overall the physician is not deemed to be an employee, some of the factors described below may well prove to be Antikickback law (Medicare Fraud and Abuse Amendments of 1977; 42 USC ' 1320a-7b(b)) violations outside the employment safe harbor or to be Stark anti self referral law (Ethics in Patient Referrals Act of 1989; 42 USC '' 1395nn, 1395q) violations outside the employment exception.
  • c. Classification Rules. A quick look at the rules demonstrates why they can be a trap.
  • i. Tax and Benefit Matters. To classify a worker for federal tax purposes, the three analytical steps described below should be taken. Keep in mind, however, that workers compensation and other state regulatory schemes will also have their own classifications which will vary from program to program and from state to state, and which are not necessarily consistent with the federal tax rules. It is helpful to use the three-step analysis described below. The basic standard for these purposes where a specific statutory definition does not apply is a common-law control rule, a rule which originally developed to determine employer liability in tort cases.
  • ii. Other Labor Law Matters. There are three standards used in classification under various other labor laws and the copyright law. See Barron, Who=s an Independent Contractor? Who=s an Employee, 14 The Lab. Law., No. 3, p. 457 (Winter-Spring 1999).
  • (1) Control Test. A test similar to the control test for tax purposes is used under the NLRA (National Labor Relations Act) (NLRB v. United Insurance Co., 390 U.S. 254 (1968)), Copyright Act (Community for Creative Nonviolence v. Reid, 490 U.S. 730 (1989)), ERISA (Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318 (1992)), and the ADA (Americans with Disabilities Act; 42 USC § 12101 et seq.) (Johnson v. City of Saline, 151 F. 3d 564 (6th Cir. 1998)).
  • (2) Economic Reality. An economic reality test (looking to Acircumstances of the whole [email protected]) is used under the Social Security Act (benefits) (U.S. v. Silk, 331 U.S. 704 (1947)) and Family and Medical Leave Act (FMLA; 29 USC § 2601, et seq.) (Siko v. Kassab, Archbold & O=Brien, 1948 W.L. 464900 (E.D. Pa) (following Fair Labor Standards Act (FLSA) cases)) and the FLSA (relating to wages and hours) (29 USC '' 203(e)(i), 203(d) and 203(g); Rutherford Food Corp. v. McComb, 331 U.S. 722 (1947)). The economic reality analysis is broader than the control analysis. It is possible to be an employee under the economic reality test but not under the control test. A 1968 Department of Labor (DOL) Opinion Letter (W&H Opinion Letter No. 832, June 25, 1968; see also W&H Opinion Letter No. 1029, Sept. 12, 1969) states that where six factors are present, the worker is likely an employee:
  • (a) worker=s limited investment in equipment and facilities;
  • (b) close supervision and high degree of control by company;
  • (c) worker=s limited opportunity for profit;
  • (d) small degree of worker=s independent initiative, judgment, and foresight needed in open market competition for success of the operation;
  • (e) high degree of permanence of the work relationship;
  • (f) the broad extent to which the services are an integral part of the company=s business;
  • (g) in addition to the six factors mentioned by the DOL, some courts look to how dependent the worker is on the company for continued work.
  • (3) Hybrid. A hybrid of the control and of the economic reality test is often used under Title VII of the Civil Rights Act of 1964 (42 USC § 2000e et seq.) (analysis of economic reality while focusing on employer=s right to control) and the Age Discrimination in Employment Act (ADEA (1967); 29 USC § 621 et seq. ) (EEOC v. Zippo Mfg. Co., 713 F.2d 32 (3rd Cir. 1983)). In addition to control, such other factors as these are considered:
  • (a) kind of occupation;
  • (b) under supervision or specialist without supervision;
  • (c) skill needed;
  • (d) who furnished equipment and work place;
  • (e) length of time worked;
  • (f) how worker paid;
  • (g) how work relationship could be terminated;
  • (h) whether annual leave provided.
  • d. Tax Classification - Special Statutory Classification. Step 1. As the first step in the three-step analytical process for tax classification of a worker, a business must determine if the worker is specifically classified by statute. Some workers, for example food and beverage workers, dry cleaning delivery persons, and most traveling sales persons, may be classified as an employee for FICA (Federal Insurance Contributions Act; Social Security and Medicare tax, see IRC ' 3101) and FUTA (Federal Unemployment Tax Act) purposes (see IRC '' 3121(d) and 3306(i)) but not necessarily for income tax purposes, while others, for example, life insurance sales persons, are treated as independent contrac­tors for FUTA, but not necessarily for other purposes (see IRC '' 3121(d) and 3306(i)). If this isn't sufficient­ly confusing, there are also complex tests of who is a qualified real estate agent or qualified direct seller entitled to be treated as independent for purposes of all three taxes.
  • i. The FICA rules define employee at IRC ' 3121(d) which includes some special classifications and the catch-all Acommon law [email protected] It is this Acommon-law [email protected] classification that causes the most problems because it applies so broadly.
  • ii. The FUTA rules define employee at IRC ' 3306(i) by cross reference to the FICA definition at IRC ' 3121(d) but makes some exceptions to the FICA definition.
  • iii. The income tax withholding rules, on the other hand, do not define employee by reference to the FICA rules, but at IRC ' 3401(c) merely say that the term employee includes certain groups (e.g., officers of corporations and officers or elected officials of governmental units). The authorities assume, without discussing in any detail, that the term employee means common law employee for this purpose.
  • iv. We will come back to common law employees in step 3. If the classification provisions reviewed in step 1 don't give a specific answer, we move on to step 2.
  • e. Tax Classification - Safe Harbors. Step 2. If the worker still is not classified for purposes of all federal taxes, a determination should be made as to whether the so called safe harbors enacted in 1978 apply. Revenue Act of 1978, ' 530. The safe harbor requirements leave much room for dispute.
  • i. First, the worker must never have been treated as an employee by the business or a predecessor and the business must have filed all required information returns, such as form 1099, with respect to the worker. This first test may lead to some disputes but is not too bad as legal standards go.
  • ii. Secondly, however, the business must have a Areasonable [email protected] for treating the worker as an independent contractor. This requires judicial precedent or ruling by the Service, a long standing recognized industry practice by a significant segment of the industry, or a past audit by the Service of the business where there was no assessment by reason of reclassi­fication of similar position. Peno Trucking, Inc. v. Comm'r, 102 AFTR 2d ¶ 2008-6433 (6th Cir. 2008) (truck drivers were employees, but state court cases involving employer's truck drivers used as precedent for § 530 relief). Each of these alternatives can raise numerous subsidiary issues likely to be difficult to resolve. Each of these safe harbors requires a document of some kind (e.g., a ruling or audit closure), except the industry practice safe harbor, so this safe harbor is the hardest to apply.
  • iii. The Service no longer requires the taxpayer to concede that its workers are employ­ees as a condition to obtaining safe harbor treatment. Also, the Service is no longer requiring that in order to qualify for a significant segment of the industry standard, at least 65-90% of the industry treat workers as independent contrac­tors. (May 10, 1995 letter from Commissioner Margaret M. Richardson to Rep. Nancy Johnson.)
  • f. Tax Classification - Multiple Factors. Step 3. Most employees will not be covered at all, or will not be covered for all purposes, by either specific statutory classification or by the safe harbors. This is where the analysis of common law employee comes in. The classification here depends on the application of a number of factors which are intended to provide an answer to the question ADid the business have the right (whether exercised or not) to control the details of the work and not just the results [email protected] Rev. Rul. 87-41, 1987-1 C.B. 296. The factors tend to be subjective and to be applied inconsis­tently. For example, a report from the House of Representa­tives described a case in which a worker who did the same kind of work for two dry wall companies was classified as an employee of one and an independent contractor of another by two different IRS agents. The Service long persisted in issuing very short rulings purporting to apply the former twenty factors but without discussing or explaining them. (See e.g., TAM 9524002.) The statutory classifications and safe harbors, for all their faults, look considerably better in contrast to the hard to apply traditional twenty factors test. The replacement (described below) to the 20 factors is no better. Also, even beyond the factors used by the Service, the courts have applied some additional factors.
  • i. General Principles. The Internal Revenue Service looks to a number of factors to test for employee status, and there are as well some other factors that have influenced court discussions. In different situations one factor will be given more weight than another and generally the absence of one factor alone will not necessarily be determinative. The more factors that apply, however, the better chance that an employer-employee relationship will be found to exist. The general thrust of the factors is to test for the sort of control generally expected in an employer-employee relationship.
  • ii. Current IRS Tests. The Internal Revenue Service for a long time looked to a 20 factor test for employee status, and there were as well some other factors that have influenced court discussions. The factors have since been consolidated by the Service into three major categories with subfactors.
  • (1) Writing. The employment agreement should be in writing.
  • (2) The Consolidated Categories. The three categories now used by the Service in analyzing whether an employment relationship exists and the subfactors to such categories, are:
  • (a) Behavioral Control. Does the business have the right to direct or control how the worker does the task?
  • (i) Instructions that the business gives the worker such as: when and where to work, what tools or equipment to use, what workers to hire to assist, where to purchase supplies and services, who is to do which tasks, what order or sequence to follow.
  • (ii) Training given to the worker to do work in a particular manner.
  • (b) Financial Control. Does the business have the right to control the business aspects of the worker=s job?
  • (i) Extent the worker has unreimbursed business expenses.
  • (ii) Extent of the worker=s investment.
  • (iii) Extent worker makes services available to the market.
  • (iv) How the business pays the worker.
  • (v) Extent to which worker can realize a profit.
  • (c) Type of Relationship. Are there facts which indicate the type of relationship?
  • (i) Written contracts describing the relationship intended.
  • (ii) Extent of employee-type benefits: insurance, pension, vacation pay, sick pay.
  • (iii) Permanency of the relationship.
  • (iv) Extent services performed are a key aspect of the regular business of the service recipient.
  • iii. The Twenty Factors. Let's also review the former twenty factors derived from Rev. Rul. 87-41, 1987-1 C.B. 296. See also Treasury Regulations (Regs.) ' 31.3121(d)-1(c)(2).
  • (1) Instructions. Does the employer have the right to give instructions to the worker? This factor is probably the single most important because it most clearly demonstrates the control necessary for a common law employment relationship.
  • (2) Integration. Is the rendering of the types of services to be performed by the worker the very reason for the existence of the employer's operation?
  • (3) Right to Discharge. Does the employer have the right to discharge the worker at will, or with a reasonably short notice period?
  • (4) Right to Terminate. Similarly to item 3, may the worker quit at will, or with a reason­ably short notice period?
  • (5) Personally Render Services. Must the worker=s services be rendered personally and not be delegated?
  • (6) Employer Hires Assistants. Similarly to item 5, may the worker hire his or her own assistants? Are all such personnel hired by the employer itself? Are all such personnel paid and supervised by the employer under the employer's general policy and not by each worker separately?
  • (7) Training. Does the employer require frequent or periodic training? Is this something more than the mere need to maintain govern­mental mandated licensing or desirable certifica­tion?
  • (8) Payment. Does the worker have a signifi­cant minimum income guaranty under the agreement? For example, is payment of compensation on an hourly, weekly, or monthly basis?

 

  • (9) Business Expenses. Does the employer pay all business and travel expenses for the worker? Is the worker required to report such expenses for payment or reimbursement under a generally applicable employer policy?
  • (10) Continuity. Does the arrangement contem­plate a continuing arrangement for an indefinite period, (as opposed to a one-shot project, a set term, etc.)?
  • (11) Hours of Work. Does the employer set the hours of work?
  • (12) Full Time. Does the worker perform full-time work for the employer? Are some employees performing very similar functions on a full-time basis as the worker who works on a part time basis?
  • (13) Work for Others. Is work for other firms be restricted? Also, if the other work is also as an employee, this would be somewhat helpful in indicating employee status.
  • (14) General Public. Are the workers= services available to the general public, or are their services (at least as to the areas relevant to the employer) available to the employer only?
  • (15) Tools and Materials. Does the employer provide all tools and materi­als, not the worker?
  • (16) Premises. Is the worker required to perform the services for the employer at the employer's premises or at such other places as the employer may direct?
  • (17) Order or Sequence. May the employer set the order or sequence of service, even if the right is exercised only infrequently, if at all?
  • (18) Reports. Is the worker is required to give oral or written reports to the employer on matters having to do with the employment?
  • (19) Significant Investment. Do the workers have to make any significant investment in such things as instruments, equipment, space, etc. in order to work for the employer? If not, this factor tends toward employee status.
  • (20) Profit or Loss. Does the employment lack a significant profit or loss aspect to it? The worker's guaranteed income tends toward employee status and any ownership in the business or in assets used by the business, and any exposure to liabilities of the business (for example, personal guarantees), would tend to be negative features on this factor. Any direct relation between compen­sation and net receipts over expenditures would tend to be a negative feature. Also, the enhancement of a worker's business reputation (advertising and such), rather than that of the employer, is treated as a negative factor. If the employer requires any relevant inventions by the worker to be treated as employer property or be assigned to the employer, this tends to indicate employee status.
  • iv. Other Factors. Other factors not specifically dealt with in the Service's 20 factors, but which are treated in other sources of common law on employees, may be relevant as well. These include:
  • (1) Skill. There is a general observa­tion, in some authori­ties, that lower skill levels tend to be associated with employees.
  • (2) Labels. The label used may help show intention, so the agreement and the parties should consistently refer to the worker in the status desired.
  • (3) Principal in Business. The principal employer being in business (rather than being not-for-profit, or some other sort of organization) tends to favor an employee-employer relation­ship.
  • (4) Intent. The intention of the parties is helpful, particular­ly in close cases, so the agreement and the conduct of the parties must be consistent with the treatment desired.
  • (5) Governmental or Regulatory Rules. That the employer need not exercise control over a certain aspect of the employee's conduct because these controls exist already by reason of outside regulatory rules concern­ing the matter, should not militate significantly against employee status. The employer may, however, take steps of its own to enforce the outside rules and apply them in day to day practice, and this would tend to show an employ­ment relationship.
  • (6) Industry Custom. This may cut in either direction.
  • (7) Insurance. Insurance coverage available only for employees helps bolster the case for employee status. Does the arrangement meet the employee definition of the policies providing coverage?
  • (8) Benefits. Fringe benefits tend to show employee status because, among other reasons, one main reason for using independent contractors is to avoid the employer paying for such benefits.
  • (9) Licenses and Taxes. Does the employer pay for the worker=s license fees, withholding taxes (federal state, FICA) and other similar payroll expenses (e.g., FUTA), memberships in professional associations, and so on?
  • v. IRS Determination. An employer can request the Service to help determine the status of a worker as an employee or independent contractor by filing Form SS-8 ADetermination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax [email protected] See also IRS Publication 15-A, AEmployers Supplemental Tax [email protected]

Langdon Owen

Website

Langdon T. Owen, Jr. is a member of the law firm of Parsons Kinghorn Harris, p.c. in Salt Lake City, Utah. Mr. Owen is a transactional lawyer who practices in the areas of estate and tax planning, business and commercial transactions involving both corporate and partnership taxed enterprises (including tax, employment, and benefit issues relating to such transactions), loans and creditors' workouts, pension and profit sharing plans, health care law, probate, and real estate.