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Tax Implications of the Employee vs. Independent Contractor Debate

July 1, 2011 4 Min Read
Richard J. Nelson, CPA Director, Tax Strategies

As part of its employment Tax National Research Project the IRS will audit 6,000 randomly selected businesses focusing on worker classification. The project began in 2010 and will continue through 2012.

The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is a complex one. It is intensely factual, and the stakes can be high. If a worker is an employee the company must withhold federal income and payroll taxes, pay the employer’s share of FICA taxes on the wages plus FUTA tax, and often provide the worker with fringe benefits, including retirement plans, it makes available to other employees. There may be state tax obligations as well. These obligations do not apply for a worker who is an independent contractor. The business sends the independent contractor a Form 1099-MISC for the year showing what he or she was paid, if it amounts to $600 or more, and no other actions are required. A reclassification from an independent contractor status to an employee status can result in significant deficiencies and possible penalties.

In determining whether an individual is an employee or an independent contractor, consult the “common law” rules that have been developed by the courts and Section 530 of the Revenue Act of 1978, which provides a safe harbor rule.

Under the common law rules developed by the courts, a worker generally is an employee for federal tax purposes if the employer has the right to control and direct the worker regarding the job he is to do and how he is to do it. The employer does not have to actually direct or control how the services are performed; it is enough if the employer has the right to do so.

The IRS takes these 20 factors and places them into three broad categories: behavioral control, financial control and the relationship of the parties. Each category contains types of information (facts) that illustrate the right to direct and control, or its absence. There is no magic formula of factors that will control the outcome. Instead, all the facts must be weighed in evaluating the extent of the right to direct and control.

The 20 Factors Are:

  1. Instructions to worker
  2. Training
  3. Integration into business operations
  4. Requirement that services be rendered personally
  5. Hiring, supervising, and paying assistants
  6. Continuity of the relationship (permanency)
  7. Setting the hours of work
  8. Requirement of full-time work
  9. Working on employer premises
  10. Setting the order or sequence of work
  11. Requiring oral or written reports
  12. Paying worker by the hour, week, or month
  13. Payment of worker’s business and/or traveling expenses
  14. Furnishing worker’s tools and materials
  15. Significant investment by worker
  16. Realization of profit or loss by worker
  17. Working for more than one business at a time
  18. Availability of worker’s services to the general public
  19. Firm’s right to discharge worker
  20. Worker’s right to terminate relationship

Section 530 can provide a safe harbor for workers who have been misclassified as independent contractors. Section 530 protection applies only if the employer: filed all federal returns consistent with its treatment of a worker as an independent contractor; treated all similarly situated workers as independent contractors; and had a
“reasonable basis” for not treating the worker as an employee. For example, a “reasonable basis” exists if a significant segment of the employer’s industry has traditionally treated similar workers as independent contractors.

If you find yourself audited by the IRS for a worker classification issue, be prepared to engage in an extensive fact gathering process. The IRS will want you to prove that the facts support the classification of your workers. You will have to support your classifications under the factors listed above. Be prepared to provide to the IRS not only your payroll records but any independent contractor agreements, employment  agreements, and employee manuals. You may have to provide invoices from and payment records for each contractor. You may also have to gather information from your contractors to support their classification as an independent contractor.

Some say the best defense is a good offense. If you are in an industry that uses a lot of independent contractors, you should proactively prepare your defense. Be familiar with the factors that determine classification. Do you have enough documentation to support the classification of your independent contractors? Consider having an independent contractor agreement that would clearly state the relationship is a non-employee relationship. If you monitor your relationships and put the relevant policies and contracts in place, you can limit your exposure to an IRS worker classification audit.

Richard J. Nelson can be reached at Email or 215.441.4600.


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Richard J. Nelson, CPA

Richard J. Nelson, CPA

Director, Tax Strategies

Business Tax Specialist, Individual Tax Specialist, Estates, Trusts, & Gifts Specialist, International Tax Specialist

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