It can be a costly mistake for both workers and businesses to wrongly classify whether a worker is acting as an employee or an independent contractor on behalf of the business. If a worker is classified as an employee, then the employer has the duty to withhold and pay income taxes, social security taxes, Medicare taxes and unemployment taxes to the IRS on wages or salary paid to the worker. If a worker is classified as an independent contractor, then the employee is responsible for his or her own tax liability and may have to make quarterly estimated payments for self-employment and income tax on monies received. Unfortunately, the distinction between independent contractor and employee is not always clear and may be subject to interpretation by the IRS on a case-by-case basis.
So, how can a business determine if a worker should be properly classified as an independent contractor or an employee?
FORMER RULE: THE “ECONOMIC REALITIES TEST”
In two cases decided on the same day, the U.S. Supreme Court formulated in United States v. Silk, 331 U.S. 704 (1947), and Rutherford Food Corp. v. McComb, 331 U.S. 722 (1947) a five-factor test that focused on the “economic reality” of the relationship between the employer and the individual to determine classification. These factors are:
- (1) the degree of control exercised by the alleged employer;
- (2) the extent of the relative investments of the putative employee and employer;
- (3) the degree to which the “employee’s” opportunity for profit and loss is determined by the “employer”;
- (4) the skill and initiative required in performing the job; and
- (5) the permanency of the relationship.
The determination of independent contractor v. employee under the “economic realities” test rests “on an analysis of the evidence as a whole as to whether the [worker] as a matter of economic reality is dependent for his livelihood upon his relationship with his alleged employer.” Robicheaux v. Radcliff Material Inc., 697 F.2d 662, 666 (5th Cir. 1983). Stated another way, “[t]he focal inquiry in the characterization process is thus whether the individual is or is not, as a matter of economic reality, in business for himself.” Donovan v. Tehco, Inc., 642 F.2d 141, 143 (5th Cir. 1981). If the worker was dependent economically on the employer for his livelihood, then he or she is properly classified as an employee. However, if the worker performed services for multiple businesses, provided his or her own insurance coverage and listed himself or herself as self-employed on his or her tax returns, then the factors may tip in favor of independent contractor classification.
FORMER RULE: THE IRS “20-FACTOR” TEST
The “economic realities” test had been subject to significant interpretation in the courts especially since several types of industries have different ways that an independent contractor v. employee can be determined. In 2013, the IRS replaced the “economic realities” test with its own 20-factor test to provide more guidance. These factors are:
- (1) Instructions: An employee receives instructions about when, where and how work should be performed. An independent contractor generally get the job done in his or her own way.
- (2) Training: Employees are often trained by the employer in how to perform their work. Independent contractors use their own methods and generally do not receive training from the client they service.
- (3) Integration: The employee’s services are usually merged into the business’s overall operation. An independent contractor’s services are usually separated from the client’s business.
- (4) Services Rendered Personally: Employees generally render services personally and do not hire or delegate to substitutes to do the work. Independent contractors can assign another to do the job in his or her place and personal services are not required.
- (5) Hiring and Supervising Assistance: An employee who hires assistance usually does so with the employer’s funds. Independent contractors who select, hire, pay and supervise any assistants used are responsible for the results of that assistant’s labor.
- (6) Continuing Relationship: An employee often continues to work for the same employer month after month or year after year. An independent contractor is usually hired to do one job with limited or indefinite duration and has no expectation of continued work.
- (7) Set Hours of Work: An employee is generally required to work or be available to work (“on call”) during hours and days set by the employer. An independent contractor generally determines their own schedule.
- (8) Full Time Required: An employee generally devotes full-time service to the employer while at work. An independent contractor cannot be required to devote full-time service to one entity exclusively.
- (9) Location Where Services Performed: An employer can mandate where an employee performs services. Independent contractors can work where they choose.
- (10) Order or Sequence of Work: An employee performs services in the order or sequence set by employer. An independent contractor controls and determines their own order or sequence of work to get to the finished product.
- (11) Regular Reports: An employee can be required to submit regular oral or written reports about the work in progress. An independent contractor is usually not required to do so.
- (12) Manner of Payment: An employee is generally paid in regular amounts by the hour or week. An independent contractor is usually paid by the job at a negotiated rate or upon acceptance of a bid to work.
- (13) Payment of Business and Travel Expenses: An employee’s business and travel expenses are generally paid by the employer. An independent contractor is usually responsible for their own expenses without reimbursement.
- (14) Furnishing Tools and Equipment: Employees are furnished all necessary tools, material and equipment by their employer. An independent contractor usually provides all of the tools and equipment necessary to complete the job.
- (15) Significant Investment: An employee generally has little or no investment in the business, but is instead economically dependent on the employer. An independent contractor usually has a substantial financial investment in their independent business.
- (16) Realize Profit or Loss: An employee usually does not realize a profit or loss in the business but is instead paid for services rendered. Independent contractors can either realize a profit or suffer a loss depending on its own revenues or expenses.
- (17) Working For More Than One Entity: An employee generally works for one employer at a time and may be prohibited from joining a competitor. Independent contractors are not subject to non-compete rules and often work for more than one client at a time.
- (18) Services Available To Public: An employee is generally not able to make services available to the public except through his or her employer’s business. An independent contractor may advertise and promote its services to the general public to attract its own separate clients.
- (19) Right To Discharge Without Liability: Generally, employees can be discharged at any time without liability on the employer’s part. Independent contractors who meet the contract terms generally cannot be fired without liability for breach of contract.
- (20) Right To Quit Without Liability: Generally, employees may quit work at any time without liability on the employee’s part. An independent contractor is legally responsible for job completion and may be liable for breach of contract for quitting prematurely.
Not all factors would apply to each situation and some factors would receive greater weight depending on the circumstances. Generally, the 20-factor test revolves around what kind of control that the recipient of services has over the worker. The more factors that weigh towards suggesting control, then the more likely the worker should be classified as an employee. Many states utilize the IRS 20-factor test in determining independent contractor vs. employee relationships for their own purposes such as state payroll tax liability.
CURRENT RULE: THE IRS “11-FACTOR” TEST
Since at least 2019, the Internal Revenue Service retired the 20-factor test and simplified the independent contractor v. employer determination into 11 factors to be weighed in three broad categories: behavioral control, financial control and the type of relationship.
Factors that show whether the service recipient has a right to direct and control how the worker completes the tasks assigned include:
- (1) Instructions The Service Recipient Gives The Worker: An employee is generally subject to the service recipient’s instructions about when, where, and how to work. For example, a business can properly be classified as an employer if it determines for the employee 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, and what order or sequence to follow. Service recipients who retain the right to control the details of work performance likely have employees, not independent contractors, as workers.
- (2) Training The Service Recipient Gives The Worker: An employee may be trained to perform services in a particular manner by the service recipient. Independent contractors ordinarily use their own methods to complete the job provided to them.
Factors that show whether the service recipient has a right to control the business aspects of the worker’s job include:
- (3) The Extent Of The Worker’s Unreimbursed Business Expenses: Independent contractors are more likely to have unreimbursed expenses than are employees. Employees may also have reimbursed expenses, but this should be uncommon.
- (4) The Extent Of The Worker’s Investment: An employee usually has no investment in the work other than his or her own time and labor. An independent contractor often has a significant investment in the equipment and business operations he or she uses in performing services for someone else.
- (5) The Extent To Which The Worker Makes Services Available To The Public: An independent contractor is generally free to seek out new business clients, advertise publicly, and maintain a separate business location from the service recipient. Employees are only available to the public in their scope of performing tasks for their employer.
- (6) How The Service Recipient Pays The Worker: An employee is generally guaranteed a regular wage amount or a salary for an hourly, weekly, or other period of time. An independent contractor is usually paid a flat fee for the job.
- (7) The Extent To Which The Worker Realizes Profits or Losses: Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss unless they had some ownership interest in the business.
Type of relationship
Facts that show the parties’ type of relationship include:
- (8) Written Contracts Describing The Relationship The Parties Intended To Create: The existence of a written contract may be the tie-breaker in close calls, but the IRS is more concerned about the nature of the work provided and not what the parties call the relationship.
- (9) Whether the Service Recipient Provides the Worker with Benefits, such as insurance, a pension plan, vacation pay, or sick pay: Employers generally have the power to grant and take away benefits benefits to employees such as insurance, pension plan, vacation pay or sick pay. An independent contractor will generally finance his or her own benefits.
- (10) The Permanency Of The Relationship: Employees are generally hired and retained by the employer to work for an unspecified and indefinite period of time, while independent contractors have no expectation for continued work with the service recipient once the job is done.
- (11) The Extent To Which Services Performed By The Worker Are A Key Aspect Of The Regular Business Of The Company: If a worker provides services that are a key aspect of the service recipient’s regular business activity, it is more likely that the company will have the right to direct and control his or her activities and suggest an employment relationship.
If an employment relationship exists under this criteria, then it does not matter if the employee is called something different such as an agent, subcontractor or independent contractor.
PENALTIES FOR MISCLASSIFICATION OF EMPLOYEES AS INDEPENDENT CONTRACTORS
If the IRS determines that a worker is an employee, then the employer has the duty to withhold and pay income taxes, social security taxes, Medicare taxes and unemployment taxes to the IRS on wages or salary paid to the worker. According to 26 U.S.C. §6656, if any person fails to deposit required employee withholding taxes to the applicable government depository on the dates required by law AND the failure is due to reasonable cause and not willful neglect, THEN that person is subject to a penalty equal to a percentage of the underpayment as follows:
- 2% if the underpayment is 5 days or less late.
- 5% if the underpayment is between 6 days and 15 days late.
- 10% if the underpayment is more than 15 days late.
- 15% if the underpayment is not deposited either within 10 days of the first IRS delinquency notice or on the day in which notice and demand for immediate payment is made.
According to 26 U.S.C. §6721 and §6722, a person who fails to file Form W-2, Form W-3 and certain Forms 1099-MISC as required by law and fails to furnish said forms to the payees as required by law is liable for penalties:
- If the taxpayer is a large company with gross receipts of more than $5 million and government entity, then the penalty is:
- If not more than 30 days late, $50 per return up to a $536,000 maximum.
- If 31 days or more late up to August 1, $100 per return up to $1,609,000 maximum.
- If later than August 1 or not at all, $260 per return up to a $3,218,500 maximum.
- If the taxpayer intentionally disregarded filing or furnishing the information return, then $530 per return with no maximum limit.
- If the taxpayer is a small business with gross receipts of $5 million or less, then the penalty is:
- If not more than 30 days late, $50 per return up to a $187,500 maximum.
- If 31 days or more late up to August 1, $100 per return up to $536,00 maximum.
- If later than August 1 or not at all, $260 per return up to a $1,072,500 maximum.
- If the taxpayer intentionally disregarded filing or furnishing the information return, then $530 per return with no maximum limit.
- A person is liable for the 26 U.S.C. §6721 filing penalty if any of the following occurred:
- The information was not filed by the due date AND reasonable cause is not shown.
- Filed on paper instead of electronically when required to do so.
- Failed to report or incorrectly reported a TIN (Taxpayer Identification Number)
- A person is liable for the 26 U.S.C. §6722 furnishing penalty if any of the following occurred:
- The payee did not get the correct information statement by the applicable date AND reasonable cause is not shown.
- Provided incorrect information or omitted information on the information statement.
According to 26 U.S.C. §6663, a fraud-related penalty of 75% applies to any portion of the underpayment if any part of the underpayment of tax for employee withholding taxes is due to fraud, unless the taxpayer had reasonable cause or acted in good faith. Fraud is the willful and intentional violation of the law, rules and regulations with the purpose of evading or defeating federal taxes. Fraud can also lead to criminal penalties such as prosecution for tax evasion. In addition, interest will accrue on any unpaid tax from the due date until the full balance is paid in full. The interest rate is determined quarterly and is equal to the federal short-term interest rate plus 3%. Interest compounds daily on unpaid balances and, unlike tax penalties, it cannot be waived.
The employer may also be subject to other tax penalties related to employee withholding taxes if not handled properly:
- FALSE INFORMATION WITH RESPECT TO TAX WITHHOLDING (26 U.S.C. §6682) – A person who makes a statement with respect to tax withholding that results in a decrease in the amounts deducted or withheld, and knew at the time the statement was made that there was no reasonable basis for such a statement, shall pay a penalty of $500.00 per statement.
- FRAUDULENT STATEMENT OR FAILURE TO FURNISH STATEMENT TO EMPLOYEE (26 U.S.C. §6674) – Any employer who furnishes a fraudulent statement (e.g. W-2) of fails to furnish a fraudulent statement to an employee is liable for a penalty of $50.00.
- AIDING AND ABETTING UNDERSTATEMENT OF TAX LIABILITY (26 U.S.C. §6701) – Any person who aids or assists in the preparation or presentation of any portion of a return, affidavit or claim who knows (or has reason to know) that the portion will be used for tax purposes and will result in the understatement of the tax liability of another person is liable for a penalty of $1,000.00 ($10,000.00 if it relates to the tax liability of a corporation). The penalty can be assessed even if the taxpayer had no knowledge of the aiding and abetting activity.
WHAT IS SECTION 530 RELIEF?
Section 530 of the Revenue Act of 1978 (often called “Section 530 Relief”) provides businesses with relief from federal employment tax obligations with respect to a particular worker not treated as an employee if three statutory grounds are met:
- (1) Reporting Consistency: The taxpayer must have timely filed the requisite information returns consistent with its treatment of the worker as a non-employee.
- (2) Substantive Consistency: If the taxpayer or predecessor treated the worker, or any worker holding a substantially similar position, as an employee at any time after December 31, 1977, the taxpayer will not be eligible for relief.
- (3) Reasonable Basis: The taxpayer must have reasonably relied on one of the following three “safe harbors”: Prior audit, judicial precedent, or industry practice.
The taxpayer must establish a prima facie case that it was reasonable not to treat an individual as an employee and cooperate fully with reasonable requests from the IRS. If granted, this relief will excuse federal employee tax obligations with respect to that person. However, it does not extend to the worker who may still be liable for the employee’s share of FICA (but not self-employment tax).
WHAT CAN YOU DO IF YOU ARE UNSURE HOW TO CLASSIFY YOUR WORKER?
If you are unsure if your worker is a employee or an independent contractor, there are two things you can do.
First, you can ask the IRS to make a decision for you. The worker or service recipient can file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. The form requests information related to the scope of service provided, the method of payment and the relationship between the two parties. Once filed, the IRS will process and generally provide a response as to the proper classification in six months or longer.
Second, if the IRS method seems too long, you can consult a tax professional. Our skilled lawyers are available to advise and assist with all of your tax needs, including helping you determine the appropriate classification of your workers.
If you have further questions about federal taxation or you need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.