The Great Debate: Employee vs. Independent Contractor– July 25, 2013

20 Questions to Help Classify Workers

Employee or independent contractor? The issue is always a tricky one to address but remains a hot button for the IRS. Independent contractors do not have payroll or income taxes withheld and are responsible for reporting their income, leaving an opportunity for unreported or underreported income — and more scrutiny. If employers aren’t careful, the wrong classification can amount to expensive penalties and fees. The good news is there is also opportunity for relief.

Common Law & Common Sense

An employee is generally defined as a worker over whom the business may legally control and direct both what must be done and how it must be done. An independent contractor is a worker over whom the business may legally and directly control only what must be done. But, generally, employers should follow the rules of common law and common sense.

The IRS has devised 20 common law tests, or questions, to help determine a worker’s status (listed below). Questions such as how the worker is paid, trained and supervised; who is responsible for expenses; and whether the worker is at risk of financial loss are examples of facts the IRS may examine.

Common sense comes into play as well. Are workers doing the same task treated differently? How do other established companies treat workers doing the same task? Does the company hold the individual out to the public as if he or she were an employee, such as listing him or her on the company website?

After careful consideration, if a worker falls within the contractor category, best practices can help minimize risk — such as executing an agreement stating the worker’s status and her commitment to properly filing returns and paying taxes.

Righting a Wrong

Historically, if the IRS determines during an audit that a business has misclassified workers, the settlement offer will typically state the following:

  • The employer agrees to properly classify workers going forward.
  • The IRS agrees to accept classifications for prior years.
  • The employer must pay an assessment equal to the full employment tax liability for one tax year. If certain conditions are met, the assessment may be limited to 25% of this amount.

Employers who have misclassified workers may voluntarily reclassify them outside of an audit via the Voluntary Classification Settlement Program (VCSP). The program takes penalties, interest and employment tax audits for prior years off the table. To qualify for the program a business:

  • Must have consistently treated workers as non-employees;
  • Must have filed all forms 1099 for the previous three years;
  • Cannot currently be under an employment tax audit;
  • Must prospectively classify appropriate employees as employees; and
  • Must pay 10% of employment taxes calculated using the reduced rates of IRC Sec 3509 for the wages in the most recently closed tax year.

Importantly, once a business decides to reclassify its workers as employees, all workers in that class must be deemed employees.

For employers that do not, or cannot, take advantage of the VCSP, Section 530 safe harbor provisions provide another avenue of potential relief.

The Top 20 Common Law Tests

The following is a list of 20 questions the IRS uses to determine if a worker is an independent contractor or employee. While no single test, nor even the combination of a majority of tests, will necessarily be determinative, a “yes” answer to any one of the questions (except #16) may mean the worker is an employee.

  1. Is the worker required to comply with instructions about when, where and how the work is done?
  2. Is the worker provided training that would enable him/her to perform a job in a particular method or manner?
  3. Are the services provided by the worker an integral part of the business' operations?
  4. Must the worker render the services personally?
  5. Does the business hire, supervise, or pay assistants to help the worker on the job?
  6. Is there a continuing relationship between the worker and the person for whom the services are performed?
  7. Does the recipient of the services set the work schedule?
  8. Is the worker required to devote his/her full time to the person he/she performs services for?
  9. Is the work performed at the place of business of the company or at specific places set by the company?
  10. Does the recipient of the services direct the sequence in which the work must be done?
  11. Are regular oral or written reports required to be submitted by the worker?
  12. Is the method of payment hourly, weekly, monthly (as opposed to commission or by the job?)
  13. Are business and/or traveling expenses reimbursed?
  14. Does the company furnish tools and materials used by the worker?
  15. Has the worker failed to invest in equipment or facilities used to provide the services?
  16. Does the arrangement put the person in a position of realizing either a profit or loss on the work?
  17. Does the worker perform services exclusively for the company rather than working for a number of companies at the same time?
  18. Does the worker in fact make his/her services regularly available to the general public?
  19. Is the worker subject to dismissal for reasons other than non-performance of the contract specifications?
  20. Can the worker terminate his/her relationship without incurring a liability for failure to complete the job?

For more information on this topic, contact a member of your Cohen & Company service team or a member of our tax department.

This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.