The question of when a person can be paid and classified as an independent contractor or must be classified as an employee has received renewed attention. As smaller businesses are faced with the implementation of the Affordable Care Act (ACA) if they have more than 50 full-time equivalent employees, there is a renewed interest in the proper classification of employees. ACA aside, this is an important distinction for both parties. Worker classification affects whether an employer is responsible for withholding federal income tax, social security and Medicare taxes as well as other employer benefits, which may include retirement contributions.
[This article is course content for the Tax Season 2016 CPE quiz, worth 3 CPE credits! Reach the quiz and additional content HERE.]
Over the years this matter has been taken to the courts to provide clarification and interpretation. In prior court cases, many factors have been considered to determine when a person is an independent contractor or an employee. Many of these court cases have focused on aspects of the degree of control the employer has over the person. Reliable resources are Supreme Court cases, Department of Labor, and the IRS. If an employer misclassifies a person as an independent contractor they may have a number of consequences. If it is determined that the person you classify as an independent contractor meets the legal definition of an employee by either the IRS or DOL, you may be required to: 1) reimburse them for wages you should've paid them under FLSA, including overtime and minimum wage; 2) pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment; 3) pay any misclassified injured employees workers' compensation benefits; and 4) provide employee benefits, including health insurance, and retirement. The IRS has refined their approach to this classification question as explained in the following. The IRS’ current guidance is in the form of Topic 762 - Independent Contractor vs. Employee: http://www.irs.gov/taxtopics/tc762.html
For federal employment tax purposes, the usual common law rules are applicable to determine if a worker is an independent contractor or an employee. Under common law you must examine the relationship between the worker and the business. You should consider all evidence of the degree of control and independence in this relationship. The facts that provide this evidence fall into three categories – Behavioral Control, Financial Control and the Relationship of the Parties.
Behavioral Control covers facts that show if the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training or other means.
Financial Control covers facts that show if the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:
• The extent to which the worker has unreimbursed business expenses,
• The extent of the worker’s investment in the facilities or tools used in performing services,
• The extent to which the worker makes his or her services available to the relevant market,
• How the business pays the worker, and
• The extent to which the worker can realize a profit or incur a loss.
Relationship of the Parties covers facts that show the type of relationship the parties had. This includes:
• Written contracts describing the relationship the parties intended to create:
• Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay,
• The permanency of the relationship, and
• The extent to which services performed by the worker are a key aspect of the regular business of the company.
The IRS has also issued guidance in Publication 15A: To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. In any employee- independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. These facts are discussed next.
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
1) Instructions that the business gives to the worker. An employee is generally subject to the business' instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:
• When and where to do the work.
• What tools or equipment to use.
• What workers to hire or to assist with the work.
• Where to purchase supplies and services.
• What work must be performed by a specified individual?
• What order or sequence to follow.
2) The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
3) Training that the business gives to the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Facts that show whether the business has a right to control the business aspects of the worker's job include:
1) The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their employer.
2) The extent of the worker's investment. An independent contractor often has a significant investment in the facilities or tools he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
3) The extent to which the worker makes his or her services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
4) How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is often paid a flat fee or on a time and materials basis for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
5) The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.
6) Type of relationship. Facts that show the parties' type of relationship include:
a) Written contracts describing the relationship the parties intended to create.
b) Whether or not the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
c) The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.
d) The extent to which services performed by the worker are a key aspect of the regular business of the company.
e) If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Further, Publications 15-A has numerous illustrations of these elements. http://www.irs.gov/pub/irs-pdf/p15a.pdf
If you want the IRS to give you a determination of whether a person or position is an employee or independent contractor, you can request for them to give you a determination by completing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. They can be submitted by the employer or the individual. Review of this four page form will give a person an even more detailed list of elements the IRS would consider.
In addition to compliance with the IRS relative to proper classification of employees, an employer also needs to be concerned with the Department of Labor and their audits for compliance with the Fair Labor Standards Act.
From the Fair Labor Standards Act Advisor: http://webapps.dol.gov/elaws/whd/flsa/scope/ee14.asp
The Supreme Court has said that there is no definition that solves all problems relating to the employer-employee relationship under the Fair Labor Standards Act (FLSA). The Court has also said that determination of the relationship cannot be based on isolated factors or upon a single characteristic, but depends upon the circumstances of the whole activity. The goal of the analysis is to determine the underlying economic reality of the situation and whether the individual is economically dependent on the supposed employer. In general, an employee, as distinguished from an independent contractor who is engaged in a business of his own, is one who "follows the usual path of an employee" and is dependent on the business that he serves. The factors that the Supreme Court has considered significant, although no single one is regarded as controlling are:
1. The extent to which the worker's services are an integral part of the employer's business (examples: Does the worker play an integral role in the business by performing the primary type of work that the employer performs for his customers or clients? Does the worker perform a discrete job that is one part of the business' overall process of production? Does the worker supervise any of the company's employees?);
2. The permanency of the relationship (example: How long has the worker worked for the same company?);
3. The amount of the worker's investment in facilities and equipment (examples: Is the worker reimbursed for any purchases or materials, supplies, etc.? Does the worker use his or her own tools or equipment?);
4. The nature and degree of control by the principal (examples: Who decides on what hours to be worked? Who is responsible for quality control? Does the worker work for any other company(s)? Who sets the pay rate?);
5. The worker's opportunities for profit and loss (examples: Did the worker make any investments such as insurance or bonding? Can the worker earn a profit by performing the job more efficiently or exercising managerial skill or suffer a loss of capital investment?); and
6. The level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise (examples: Does the worker perform routine tasks requiring little training? Does the worker advertise independently via yellow pages, business cards, etc.? Does the worker have a separate business site?).
Another resource from the DOL on this topic is - http://www.dol.gov/whd/regs/compliance/whdfs13.pdf
Remember that some employees are exempt from various provisions of the law. To explore the broad categories of these exemptions or to obtain further information about the exemptions, go to http://webapps.dol.gov/elaws/whd/flsa/screen75.asp
Why does it matter? If an employer misclassifies a person as an independent contractor they may have a number of consequences. If it is determined that the person you classify as an independent contractor meets the legal definition of an employee by either the IRS or DOL, you may be required to: 1) reimburse them for wages you should’ve paid them under FLSA, including overtime and minimum wage; 2) pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment; 3) pay any misclassified injured employees workers’ compensation benefits; and 4) provide employee benefits, including health insurance, and retirement.
There is a “perfect storm” brewing related to worker classification. As the smaller employers with more than 50 FTEs will be required to offer affordable healthcare insurance or pay a penalty and the potential change of the requirements related to payment of overtime, there will be huge incentive for business owners to avoid one or both of these by classifying workers as an independent contractor vs. an employee. I expect this question is one that many CPAs both in CPA firms and those employed in business and industry will be facing. I have made a conscious effort in this article to give you information verbatim from DOL and IRS vs. giving you commentary or opinions.
Jerry Love is the sole owner of Jerry Love CPA, LLC in Abilene, Texas. He graduated from Abilene Christian University. In addition to being a CPA, he has also earned the designations of PFS, CFP, CVA, ABV, CITP, CFF, and CFFA. In 2006-07, Jerry was the Chairman of the Texas Society of CPAs.