“Worker classification continues to be a point of contention with the Internal Revenue Service (IRS) and the Department of Labor (DOL).” according to Plante Moran the nation’s 13th largest certified public accounting and business advisory firm in the United States.
The use of independent contractors saves employers significant money on federal and state employment taxes and allows them to avoid having to pay employee benefits. The need to ensure appropriate worker classification has increased due to elevated IRS and DOL enforcement. This increased enforcement activity can result not only in additional taxes and penalties, but also in additional exposure from employees making claims against the employer for employee benefits.
Employee vs. Independent Contractor
A worker may be classified as either an employee or independent contractor. The proper classification will be based on the facts and circumstances surrounding the relationship. The IRS considers three categories of evidence when determining whether a worker is an employee or independent contractor: behavioral control, financial control, and the type of relationship. For behavioral control, the key distinction is the organization’s ability to control the worker.
When evaluating financial control, it is important to consider if the individual is free to perform the same services elsewhere in the market. Other factors to consider include who bears the risk of profit and loss, how the worker is compensated, and if the worker incurs unreimbursed business expenses.
The type of relationship between the organization and the worker is evidenced by the permanency of the relationship, whether employee-type benefits are provided to the worker, whether the worker performs tasks similar to other employees, and whether the services provided represent the organization’s core business.
In essence, an employee is an individual who performs services for an organization and is subject to the organization’s control regarding what will be done and how it will be done. An independent contractor is an individual who performs services for an organization to achieve a desired result.
Correction of a Misclassification
There are three options available for organizations that may have misclassified workers. The first option to consider is whether Section 530 Relief applies. Under Section 530 of the Revenue Act of 1978, organizations will not owe employment taxes for misclassified workers if certain requirements are met. First, the organization has to have a reasonable basis for treating the workers as independent contractors. Reasonable basis can include judicial precedent, prior audit results, or a long-standing industry practice. The second requirement is that the organization must show it has treated all workers doing similar work consistently and finally, organizations must at all times have timely filed all federal tax returns consistent with treatment of the workers as independent contractors and not employees.
Another option is the Voluntary Classification Settlement Program (VCSP). Organizations can apply for the VCSP in order to properly classify workers for future tax periods. Organizations would be required to pay 10 percent of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year if those workers were classified as employees for such year, determined under the reduced rates of section 3509(a) (generally, 1.5% of employee’s wages, plus 20% of the employee FICA liability, plus 100% of the employer’s FICA liability), with no interest or penalty charges. There are several eligibility requirements for the VCSP: all similar workers must be consistently treated as nonemployees, all required Forms 1099, consistent with the nonemployee treatment for the workers to be reclassified must be filed for the previous three years, and the organization cannot be currently under IRS employment tax audit. Furthermore, the taxpayer cannot be currently under audit concerning the classification of the class or classes of workers by the Department of Labor or by a state government agency.
Under an IRS examination, if the organization has timely filed all required Forms 1099 with respect to the workers and treated the individual worker consistently for the period, the organization may qualify for the Classification Settlement Program (CSP). If eligible for CSP, qualified organizations may be taxed at reduced rates and generally will be assessed for no more than one year’s liability. It is important to note that the CSP prospectively binds the IRS and the taxpayer to mutually-agreed-upon worker classifications and a related tax treatment for future tax periods.
The IRS can assess 100 percent of employment taxes that should have been paid, plus penalties and interest. In addition, the employer may have exposure to provide retroactive employee benefits to misclassified independent contractors. Organizations have options available to minimize their exposure and to correct misclassified workers.
Resources available to assist in classifying workers include Revenue Ruling 87-41, which contains guidelines such as twenty factors to determine whether sufficient control exists to create an employer-employee relationship. In addition, Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can also be used to assist with the classification of a worker. An organization can submit Form SS-8 to the IRS for an official determination; however, the IRS is likely to apply a conservative interpretation and conclude the worker is an independent contractor. Once the IRS rules on a worker’s classification, the IRS’s decision is binding.
Worker classification continues to be an area of focus for the IRS. Be sure to reevaluate all independent contractors for appropriate classification, and document your conclusions. For additional information, contact your tax professional for advice.