By Heather A. Kmetz
Published Tuesday, January 11, 2005 in The Daily Journal of Commerce
Unless you are a licensed real estate agent or an officer of a corporation, there may not be a clear cut answer as to whether you should be reporting as an independent contractor or as an employee for tax purposes. Although these two positions are clearly defined in the Internal Revenue Code as an independent contractor and an employee, respectively, there are very few positions that have such clear authority. The vast number of people must rely on a subjective "facts and circumstances" test to evaluate whether services are provided within an employer-employee or a service recipient-independent contractor relationship.
A person is generally an employee if the person providing the services "is subject to the will and control of the employer not only as to what shall be done but how it shall be done," according to the Internal Revenue Service. It is not necessary that the employer actually control the manner in which the services are performed; rather, it is sufficient that the employer has a right to control.
Based on an examination of cases and rulings considering whether a worker was an employee, the IRS developed a list of 20 factors to consider when choosing a classification. The degree of each factor's importance varies depending on the occupation and the factual context in which the services are performed. The list is mere guidance; the IRS is permitted special scrutiny in applying the factors to assure that formalistic aspects of an arrangement designed to achieve a particular classification will not obscure the substance of the arrangement.
Safe Harbor Employment Tax Rule
Because the facts and circumstances test for determining whether a worker is an employee or an independent contractor is subjective, taxpayers attempting to classify workers may - in good faith - come to a different conclusion than the IRS. For this reason, a special "safe harbor" rule was crafted to protect individuals and companies from innocent misclassifications. However, because the IRS also recognizes that misclassification may be deliberate (in order to take advantage of actual or perceived tax and non-tax benefits of independent contractor status), the safe harbor rule is quite narrow.
Subject to several requirements, the rule generally allows a taxpayer to treat a worker as not being an employee for employment tax purposes (but not income tax purposes), regardless of the individual's actual status under the facts and circumstances test, if the taxpayer had a reasonable basis for such treatment. A reasonable basis is considered to exist if the taxpayer reasonably relied on: (1) past IRS audit practice with respect to the taxpayer, (2) published rulings or judicial precedent, or (3) long-standing recognized practice in the industry of which the taxpayer is a member. Reasonable reliance is generally found to exist under past audit practice if the IRS failed to raise an employment tax issue on audit, even if the audit was not related to employment tax matters.
This safe harbor relief is available with respect to an individual only if certain additional requirements are satisfied. One of these requirements is that all tax returns and informational returns (for example, Form 1099) be properly filed.
Legal Requirements for Each Classification
The Internal Revenue Code requires that employers making payments of wages to employees withhold federal income taxes from those wage payments in accordance with tables or computational procedures prescribed by the IRS. Each employee must file with his or her employer a Withholding Allowance Certificate (Form W-4) on which the employee claims a specific number of withholding allowances based on family size, employment status, itemized deductions and other matters. The employer then uses tables issued by the IRS to compute the correct amount of federal income tax withholding. The amount of wages paid and the amount of income taxes withheld must be reported to the IRS and to the employee on Form W-2. If an employer-employee relationship exists, wages paid are subject to Social Security taxes under the Federal Insurance Contributions Act (FICA) and unemployment taxes under the Federal Unemployment Tax Act (FUTA), and the service recipient is required to withhold and pay over these employment taxes.
No income tax withholding is generally required on payments made to independent contractors. As such, independent contractors are generally required to make quarterly estimated payments on compensation received. Additionally, if a service recipient pays out $600 or more in a calendar year to an independent contractor, the service provider must file an information return (Form 1099) reporting such payments. If there is no employer-employee relationship, the service recipient is not subject to employment taxes. Independent contractors pay self-employment tax under the Self-Employment Contributions Act (SECA), in lieu of FICA taxes, and are not subject to FUTA - but are also not entitled to related unemployment benefits.
It is difficult to generalize about the imposition of civil penalties by the IRS in disputes regarding classification of workers because the specific facts, behavior, and intent in each dispute can vary considerably from case to case and because the IRS has significant discretion in most instances in determining whether a particular penalty should be imposed and whether reasonable cause for abating the penalty exists. Each individual penalty applies to an act (or omission) enumerated in the penalty provision. Because some disputes regarding classification of workers may involve multiple acts (or omissions) enumerated in different penalty provisions, it is possible that multiple penalties may apply in some disputes.
A reporting penalty will be imposed against any person who fails to file a correct information return (such as Forms W-2 and 1099) with the IRS or furnish a correct payee statement to a taxpayer on or before the prescribed due date. The penalty varies based on when - if at all - the correct information return is filed and provided to the taxpayer. If the failure to file and furnish a correct payee statement is because of intentional disregard of the requirement, the penalty will generally be doubled.
An accuracy-related penalty is assessed at a rate of 20 percent against the portion of any underpayment that is attributable to any negligent substantial understatement of income tax or misstatement of valuation. If an underpayment of tax is attributable to negligence, the penalty applies only to the portion of the underpayment that is attributable to negligence - rather than to the entire underpayment of tax. Negligence includes any careless, reckless or intentional disregard of rules or regulations, as well as any failure to make a reasonable attempt to comply with the applicable provisions.
A fraud penalty is assessed at a rate of 75 percent against the portion of any underpayment that is attributable to fraud.
Any penalty may be waived for "reasonable cause," which generally requires that the taxpayer prove there were significant mitigating factors present - such as the fact that a person has an established history of complying with the information reporting requirements. Of course, it is best to seek legal counsel when a tax classification is in doubt, as this would be a significant mitigating factor should the IRS seek to impose penalties as a result of such classification.
20 Factors to Consider when Classifying Service Providers
A majority of "Yes" responses suggests the worker is an employee. A majority of "No" responses suggests the worker is an independent contractor.
Related Practice Areas
- Is the worker required to comply with instructions about when, where and how to perform the work?
- Does the service recipient train the worker?
- Are the worker's services integrated into the business operations of the service recipient?
- Must the worker personally provide the services?
- Does the service recipient supervise the worker?
- Is there a continuing relationship between the worker and the service recipient?
- Does the service recipient set the worker's hours?
- Is the worker required to devote substantially all of such worker's time to the service recipient?
- Does the worker do the work on the premises of the service recipient?
- Must the worker perform services in the order set by the service recipient?
- Is the worker required to make reports to the service recipient?
- Is the worker paid by the hour, the week or the month?
- Does the service recipient pay the worker's business and traveling expenses?
- Does the service recipient provide the worker with the tools necessary to complete the work?
- Does the service recipient invest in the facilities used to perform the work?
- Is the worker's compensation for performance of services unrelated to the profit or loss of the service recipient?
- Does the worker provide services solely to the service recipient?
- Are the services of the worker offered only to the service recipient (and not to the general public)?
- Does the service recipient have the right to discharge the worker?
- Does the worker have the right to terminate the relationship without incurring liability?