Treating a worker who provides services on your behalf as an “independent contractor” rather than an “employee” has numerous benefits for tax purposes. If the worker is an “employee,” the business for which the services are provided must withhold federal, state and local income tax (where applicable) and the employee’s share of Social Security/Medicare tax. In addition, the business for which the services are provided must pay the employer share of Social Security/Medicare as well as federal and state unemployment taxes and a variety of other benefits. On the other hand, if the worker is an “independent contractor,” the primary responsibility of the business for which the services are provided is to issue a Form 1099 Information Return to the worker and to file a copy with the Internal Revenue Service.
The issue of the appropriate tax treatment of workers has been a source of continuing challenge for both industry and the Internal Revenue Service. In 1978, in response to aggressive employment tax audits of small businesses by the IRS under which the classification of workers being treated as “independent contractors” was changed to the status of “employees,” Congress enacted Section 530 of the Revenue Act of 1978, which was to be in effect for one year. If a business met the criteria of Section 530, the classification of the worker as an “independent contractor” would be allowed even if the IRS believed the worker was, in fact, an “employee.” Basically, to meet the safe-harbor of Section 530 required the following:
The “employer” does not treat the individual as an employee for any period;
- The “employer” does not treat any other individual holding a substantially similar position as an employee for purposes of employment for any tax period;
- All required federal tax returns (for example, Forms 1099 are issued to the workers) are filed by the “employer” on a basis consistent with its treatment of the individual as a nonemployee; and
- The taxpayer has a reasonable basis for not treating the individual as an employee. “Reasonable basis” includes: (a) judicial precedent or IRS rulings; (b) a past IRS audit; or (c) a long standing practice of a significant segment of the relevant industry; or some other “reasonable basis” satisfactory to the IRS.
The expectation was that Congress and/or the IRS would clarify the issue during this one-year period. More than 30 years later, Section 530 is alive and well and continues to provide a safe-harbor for the business for which the services are being provided. If the conditions of Section 530 are met, the business can continue to treat the worker as an “independent contractor” despite the IRS contention that the worker should be treated as an “employee.” If the status of a worker is successfully challenged by the IRS, in addition to the tax due, there are significant interest and penalties applicable for all open tax years, i.e. generally three years.
Is the Worker an “Employee” or an “Independent Contractor?”
Whether a worker is performing services as an “employee” or as an “independent contractor” depends upon the facts and circumstances and is, generally, determined under a common law test of whether the service recipient has the right to direct and control the worker as to how to perform the services. In recent years, the IRS has been considering the evaluation of this issue by looking to the following “tests:”
- Behavioral Control, i.e., facts that show whether the business has a right to direct and control how the worker does the task for which the worker was hired.
- Financial Control, i.e., facts that show whether the business has a right to control the business aspects of the worker’s job. This evaluation includes a review of the financial investment required by the worker to perform the services.
- Relationship of the Worker and Firm, i.e., how does the business represent the worker to its customers (for example, employee, partner, representative or contractor) and under whose business name does the worker perform these services.
IRS Voluntary Worker Classification Settlement Progam
The Voluntary Classification Settlement Program (VCSP) provides an opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit. Under the program, eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past. The VCSP is available to many businesses, tax-exempt organizations and government entities that currently erroneously treat their workers or a class or group of workers as nonemployees or independent contractors and now want to treat these workers as employees prospectively.
To participate in the VCSP, an application (Form 8952, Application for Voluntary Classification Settlement Program) must be filed with the IRS at least 60 days before the applicant wants to begin treating the workers as “employees.” To be eligible, an applicant must:
- Consistently have treated the workers in the past as nonemployees; and
- Not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.
Under the VCSP, an employer will be required to pay only 10 percent of the employment tax liability for which it would have been responsible had it classified the workers at issue as employees for the most recent tax year, as determined under reduced tax rates identified in §3509 of the Internal Revenue Code.1 No interest or penalties will be due, and the applicant will not be audited on payroll taxes relating to the workers in issue for prior years. The applicant accepted into the program will be subject to a special six-year statute of limitations for the first three years under the program, instead of the general three-year statute of limitations that applies to payroll taxes.
IRS and DOL Team Up To Educate Employers and Ensure Compliance
On September 19, 2011, the IRS and the United States Department of Labor (DOL) signed a memorandum of understanding, pledging to work in tandem to reduce employer misclassification of workers as independent contractors or nonemployees. This partnership supports the IRS’ February 2011 launch of its audit program, wherein the agency pledged to randomly examine 6,000 companies for worker misclassification over the next three years in hopes of raising $7 billion in lost tax revenue stemming from employee misclassification.
The IRS and DOL will work together to educate employers on classification issues and to coordinate law enforcement efforts to ensure compliance with federal tax and wage and hour laws. Additionally, 11 states — including Connecticut, Maryland and New York — have agreed to work with the DOL to curb worker misclassification through information sharing.
These agreements may subject violators to more than one fine for the same violation, as participating state and federal governments will share information, with each entity able to impose its own sanctions for violations of law within its jurisdiction. For example, if a participating state agency fines an employer for worker misclassification, that state agency will then share its information regarding the delinquent employer with the DOL, which could then impose its own fine on the employer. Further, the DOL would then share the information that it has collected with the IRS, which could then audit the employer and, if warranted, impose tax liability on the offending taxpayer.
In the future, the IRS can be expected to be aggressive in addressing the issue of worker classification. Despite being treated as an independent contractor, a worker can seek a determination of his or her status as an “employee” versus “independent contractor” by filing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). Generally, the IRS will conclude that the worker has the status of an “employee.” By doing so, the concern for the business is whether such a determination will be followed by an audit. Generally, the concern of the business is heightened if there are many similarly situated workers being treated in the same fashion.