Employee vs. Independent Contractor

If you think you know the answer as to which way to treat the individuals working for you, you better be careful.

By Robert K. Darrell, CPA

How many times have you hired someone to work for you, and said to yourself, "I'm going to pay this person like a subcontractor?" I'm sure that situation has occurred too many times to count. For most small business owners, this question can quickly become a difficult and overly complex problem. If you can find the criteria used by the IRS in making such a decision, you will discover it to be a set of rules difficult to understand. If you don't make the correct decision, the consequences can spell disaster.

Sometimes the Truth Hurts

Let me start by telling you a true story. Several years ago, I was contacted by a new client; the type of business really doesn't matter. The owner had started his business about two years before and had just received a letter from the Internal Revenue Service that he was going to be audited for payroll tax purposes, (including all forms of compensation paid). Some of the 20 factor test questions (1) or criteria that the IRS used in the audit to determine the proper tax status of my client's "independent contractors" were as follows:

1. Do you supervise the workers?
2. Do they work on your premises or job site?
3. Do they use your tools or equipment?
4. Do they use your materials or supplies?
5. Are they paid a fixed salary or by the hour?
6. Do you control their hours or can they come and go as they please?
7. Do they have a contract?
8. Do they perform the same work for more than one company at the same time?
9. Is there a continuing relationship?
10. Do you set their hours?
11. Is full time work required?

My client had three individuals who worked for him and had made the decision, "They are contractors and I'm going to give them a 1099." In my client's mind, just like most other small businesspeople, that meant that he was not obligated to pay any payroll taxes.

That decision was a costly mistake.

These three individuals were being paid about $25,000 each. After applying the IRS' 20-factor rules, the IRS auditor determined that these three individuals were, in fact, employees and not independent contractors. The audit covered the first two years that this client was in business. When the audit was finally over, the client was shocked to learn that he owed back payroll taxes to the IRS for all amounts paid his "independent contractors."

The auditor determined that the client had failed to withhold and pay, in a timely manner, the following amounts: the newly classified employee's share of Social Security taxes (6.2 percent of total compensation) and Medicare taxes (1.45 percent of total compensation), not to mention the employer's matching portions of these taxes. Neither had the federal income taxes been withheld, but the IRS auditor let this issue go in this audit because all these workers had filed returns and paid the taxes due, contrary to the experience of many businesses. These payroll tax liabilities amounted to roughly $22,900 for the two years in question. Since my client was responsible to withhold these taxes and didn't, he was held responsible for both the employer's and employees' portions of the payroll taxes. Additionally, he was made to report and pay the federal unemployment tax (.8 percent) on the first $7,000 of each worker's earnings for each year, another $336.

And that still wasn't the end of the story. The IRS assessed my client because he failed to make timely payments of the payroll taxes, failed to file timely and accurate quarterly and annual payroll tax returns and failed to file forms W-2 for the worker's earnings or report the proper amounts which should have been withheld. He also filed 1099s that should have not been filed. The tax owed amounted to around $23,000. Then came the penalties for all the failures to file. The result amounted to a payroll tax liability of just over $43,000. To add insult to injury, the IRS shared this information with the Tennessee Department of Employment Security which cost him an additional $2,500 in taxes and penalties.

This true story is an extreme example of the price a small business owner can pay for making the wrong choice on how to classify and pay the individuals who work for them as employees or independent contractors.

Process Eased

To determine whether individuals are employees or independent contractors for federal tax purposes requires a look at the relationship between the individuals providing the service and the party receiving the service. All factors of the relationship must be examined. This includes the degree of control of the party receiving the service as well as the degree of independence of the individuals providing the service.

Factors that help make this determination fall into three general categories: financial control, behavioral control and type of relationship.

1. Financial Control - This set of facts helps determine if the party receiving the service has the right to control the individuals providing the service. These facts include:
   1. Whether individuals have a significant investment in assets they use in performing their services. This investment in assets usually indicates an independent contractor relationship.
   2. Whether individuals make these services available to other companies in the market place on the same basis, which indicates independent contractor status.
   3. Whether individuals have unreimbursed expenses. Employees are usually reimbursed for out of pocket expenses, while independent contractors are not. Recurring expenses paid by individuals are a fact that must be considered.
   4. Whether individuals have the ability to make a profit or realize a loss. Independent contractors could realize profits or losses from their services, not employees.
   5. Whether individuals are paid by the hour, week or by the job performed. Employees are usually paid by the hour, week or month.
2. Behavioral Control - This set of facts is relative to the degree of control the party receiving the service has over individuals providing the service. These facts include:
   1. Whether individuals receive instructions on how to perform necessary tasks. Employees are usually required to follow sets of guidelines on how a specific job is to be performed. Guidelines usually specify a step-by-step process with an expected end result. Independent contractors usually set their own guidelines.
   2. Whether individuals receive training. If individuals have to be trained to perform tasks relative to the services they are performing, they are usually employees.
3. Type of relationship - This set of facts is relative to the length of time a relationship exists between individuals performing services and parties receiving services. These facts include:
   1. Whether there is a written contract between the parties that specifies the terms of the agreement, such as: length of the relationship, description of services to be performed and compensation. This arrangement usually indicates independent contractor status.
   2. Whether the relationship is to be permanent. Will the relationship continue for an indefinite period of time or is it for a specified duration or project? An indefinite relationship would indicate an employer-employee relationship.
   3. Whether employee-type benefits are provided by the party receiving the service. This arrangement would indicate that an employer-employee relationship exists.
   4. Whether the party receiving the service has the right to direct or control the work that is performed by the individual. Employees are usually supervised and have their work controlled or reviewed.
   5. Whether the services performed by individuals are a necessary, ongoing portion of the products being produced and the party receiving the service treats it as its own service. Employees have a permanent, ongoing relationship, not independent contractors.

In order for individuals providing services not to be considered an employee and the company receiving the service not to be considered an employer, all of the above facts must be considered. Some of the facts suggest an employer-employee relationship, while others indicate an independent contractor status.

Section 530 Safe Harbor

The safe harbor rule of Section 530 minimizes the uncertainty of taxpayers concerning the proper treatment of workers as employees or independent contractors for purposes of employment taxes. Under this rule, an individual will not be reclassified as a common-law employee for employment tax purposes provided the taxpayer meets the following requirements:

1. The taxpayer did not treat the worker as an employee for any period.
2. In the case of periods after Dec. 31, 1978, all federal tax returns (including information returns) required to be filed by a taxpayer with respect to a worker are filed on a basis consistent with the worker not being an employee. For example, Form 1099 must be timely filed for each worker treated as an independent contractor.
3. The taxpayer (or a predecessor) did not treat any workers holding a substantially similar position as an employee for employment tax purposes after Dec.31, 1977.
4. The taxpayer has a reasonable basis for not treating the worker as an employee. Three methods are provided that establish a reasonable basis for not treating a worker as an employee. However, the Section 530 safe harbor does not apply to technical services performed after Oct. 22, 1986, pursuant to an arrangement between the employer and another organization.

An employer is considered to have a reasonable basis for not treating the worker as an employee if the employer's treatment of the individual was based on any of the following:

1. judicial precedent, published rulings, technical advise to the employer or a letter ruling to the employer;
2. past examination of the employer by the IRS in which there was no assessment attributable to the treatment for employment tax purposes of individual holding substantially similar to the position held by this individual; or
3. long-standing recognized practice of a significant segment of the industry in which the individual was engaged.

IRS instructions to field auditors indicate that an employer unable to show that its treatment of an individual was based on one of the safe harbors above nonetheless may be entitled to safe harbor relief if it can demonstrate, in some other manner, a reasonable basis for not treating the individual as an employee. Further, IRS states that the reasonable basis requirement is to be construed liberally in favor of the employers.

Conclusion

Be sure that you and your staff with hiring responsibilities know the difference between an employee and independent contractor. While there are a number of factors that must be looked at, the tests for independent contractor status are relatively simple. Are you making the wrong choice? Look at the example above. If you say, "I can't afford to pay these individuals as employees," look at the devastating consequences that can occur if and when you get audited. You need to make the correct choice from the beginning so the question doesn't arise later.

If and when business owners find themselves under audit, there is a possibility of some relief from penalties, which are provided for under Section 530 of the Revenue Act of 1978.

Another item that should be noted is that the IRS has changed its posture and approach while conducting audits. In 1996, the IRS revised its procedures for evaluations of employees vs. independent contractors. The IRS conducted extensive training and directed employees responsible for those evaluations to do so based on the new guidelines which changed the IRS' posture from that of "guilty until proven innocent" to "innocent until proven guilty."

The employee vs. independent contractor question has been a problem that has plagued small business owners for decades, and I'm sure that it will for years to come. The above set of facts should help you make this determination easier. If you have any doubt about how to apply these tests in your specific circumstances, seek the help of a certified public accountant who is qualified to help you make these determinations.

End Note

(1) The full text of the 20 question test including issues, facts, situations and law and analysis can be found in IRS Revenue Ruling 87-41, 1987-1 C.B. 296.

About the author

Robert K. Darrell, CPA is president of Riddle, Darrell and Associates, CPAs, a certified public accounting firm in Murfreesboro, Tenn. Darrell is a member of the Tennessee Society of Certified Public Accountants, the state professional organization for CPAs with more than 8,000 members in all areas of public practice, government & education, and business & industry, and its Nashville Chapter. The TSCPA's Nashville Chapter is one of eight chapters across the state with more than 2,900 members in 20 counties. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.