Worker classification has been a battleground between the IRS and business owners for over 40 years. This issue is likely to face more employers in the next year as the economy begins to pick up and businesses begin to need additional help. Coming off a difficult 2009, many businesses will be reluctant to hire full-time employees, turning instead to arrangements with workers that may look more like an independent contractor relationship. Several significant announcements in the last year have made it clear that this issue is once again at the top of the IRS priority list.
Workers performing services for a business can be classified as either employees or independent contractors. Determining the appropriate classification for a particular worker can sometimes be difficult. In the 1980s, the IRS set forth a list of 20 factors to consider when determining whether a person providing services is an employee or independent contractor. The degree of importance of each factor varies depending on the occupation and factual context in which the services are performed. Generally, the more control the business has over the individual, the more likely it is that the individual will be considered an employee. By way of example, several of the more important factors and their application are the following:
- A worker who is required to comply with other persons’ instructions about when, where, and how he or she is to work, is ordinarily an employee.
- Training by the service recipient indicates an employer/employee relationship.
- The establishment of set hours of work by the service recipient is a factor indicating control and an employee relationship.
- Payments made by the job or on a straight commission basis generally indicate that the worker is an independent contractor.
- If the service recipient ordinarily pays the worker’s business expenses, the worker is ordinarily an employee.
- If a worker performs more than de minimus services for a number of unrelated persons at the same time, that factor generally indicates that the worker is an independent contractor.
The IRS refined the 20 factor test in an advisory memorandum that it published in 2001. That memorandum essentially consolidated the factors into three categories.
- Behavioral Control
The behavioral element examines the degree of control the business has over the worker. If the worker controls the method by which a project gets done, the relationship looks more like that of an independent contractor.
- Financial Control
The financial element examines whether the worker has the ability to make additional profit if the worker can control expenses and other efficiencies.
- Relationship of the Parties
Finally, the relationship element examines factors such as the duration of the relationship and whether the worker provides services for multiple recipients.
Safe Habor Rules
Due to the inherent confusion in the rules discussed above, a series of “safe harbor” rules allow a business to treat a worker as an independent contractor if certain criteria are met. These rules allow a business that categorizes a class of workers as independent contractors in good faith to avoid a re-classification by the IRS, a situation which can be devastating to a business where the number of employees in that class is significant. The requirements of the safe harbor provisions are based on the business having a “reasonable basis” for such treatment. A reasonable basis for this purpose can be established by existing case law or rulings that analyze the tax status of similarly-situated workers. If the business has a reasonable basis for such treatment, and has consistently treated all workers in the same class in the same manner, this can establish a presumption that the treatment is correct and therefore, not subject to challenge by the IRS.
This past summer, the Government Accountability Office (GAO) issued a report concluding that worker misclassification is contributing to the “tax gap” and made 19 recommendations for how this situation can be remedied. Included in these recommendations were:
- Define misclassification as a violation under the Fair Labor Standards Act.
- Clarify the distinction between employees and independent contractors under federal law.
- Require businesses to provide standardized documents to workers explaining the classification systems and their rights and responsibilities thereunder.
- Require businesses to withhold taxes for certain independent contractors.
- Require service recipients to file Forms SS-8 for all new independent contractors.
While these are only suggestions, any one of these recommendations would be a significant, detrimental change for businesses that use independent contractors.
Earlier in the year, the Treasury Inspector General for Tax Administration published a report concluding that worker misclassification contributes significantly to budgetary shortfalls and imposes numerous other costs on the economy. The report recommended that the IRS develop and implement an agency-wide employment tax program, in part, to improve compliance and reduce the tax gap. In response, the IRS noted that several projects were under way to develop these types of programs aimed at increasing compliance with the rules concerning the classification of workers, including an employment tax National Research Program, which will involve the employment status review of a significant number of randomly selected employers over the next few years.
Finally, legislation was introduced in September aimed at “reversing the trend of the misclassification of employees as independent contractors.” This legislation would modify the standards for the safe harbor treatment discussed above, making it more difficult for businesses to meet the safe harbor requirements. Specifically, the reasonable basis test would only be met if the employer had a written determination from the IRS as to the classification of the worker in question (or a worker holding a substantially similar position) or the IRS had reviewed the status on audit and not proposed any changes. This legislation would also increase the penalties for failure to file certain information returns related to employees.
Between the government reports, the IRS's stated intention to increase audit activity in this area and the proposed legislation, it is clear that employee classification is an issue that will see increased activity. Even the President’s 2011 budget addresses the need for reform concerning worker classification as one area where revenues could be increased, and indicates that some of the GAO recommendations are being considered. For business owners, problems can be avoided by objectively reviewing the classification of workers and making a determination of status based on the existing legal criteria. This analysis should be updated as new legislation or related IRS rulings shed more light on the government’s current position on the worker classification issue.
For more information about the classification of your workers, please contact:
Mark D. Klimek
David M. Kall
Tax planning needs to be strategic. We consult with businesses at all stages of their development, from the initial choice of entity, through acquisition and other growth transactions, to business succession planning, and dispositions. Our tax advisors also work closely with clients on individual tax planning. Our attorneys provide businesses and individuals with comprehensive counseling in all areas of federal, state and local taxation.