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Worker Classification: The Thin Line between Employees and Independent Contractors

Uncle Bill, Emu Farmer

To discuss the thin line between employees and independent contractors, let’s imagine the following scenario—if you will indulge me.

Thin Line between Employees and Independent ContractorsYour Uncle Bill operates a successful emu farm in southeastern Maine, so successful in fact that he finds himself unable to do the work on his own. (Uncle Bill no longer has your cousin Leroy to lean on, due to his most recent “run in” with the law involving a charge of driving a riding lawnmower while intoxicated, a frolic and detour which left the mayor’s lawn without his prize-winning tulips and the sheriff’s blind dog “Trooper” with a lingering paranoia of anyone whistling Lynyrd Skynyrd.)

Bill placed an advertisement in the Biddeford Courier, seeking a motivated, young “associate,” who is quick on his or her feet, not scared easily by friend or fowl, and who has a reasonably good sense of humor. (Bill included the last bit in response to the sudden departure of his last farmhand, a college student whose idealistic view of the world clashed with Bill’s callous remarks about freeloading hippies, the ozone layer, personal hygiene, foreigners, and three excited utterances so profane that they would have made a pastor weep.)

Ever conscientious about the tax ramifications of his actions, Bill calls you early on a Tuesday morning to inquire whether his new right-hand man (or left-hand lady) should be treated as an employee or an independent contractor. After your countless lectures to Bill about consulting you before he makes a decision that will have lasting tax consequences, you are rather impressed that Bill came to you before the IRS came to him first. A blind squirrel finds a nut every once in awhile, you muse to yourself.

Although you are certain that Bill only paid attention to the part of the previous employee-vs-independent contractor conversation that dealt with not having to withhold (and pay over to the IRS) federal income tax from an independent contractor’s pay, you are nonetheless impressed that something from your conversations with him, no matter how small a shred, may have actually penetrated that oddly-shaped and intensely-dense skull of his.

Idiot Sandwich Worker Classification

You explain to Bill that before you can know how to treat payments made to his new worker for services, you must first understand the nature of the business relationship that exists between Bill and said worker. The IRS has certain tests to determine worker classification, you tell him, and somehow the sound of his mind wandering to emu-related thoughts decidedly unrelated to taxation is as audible to you as the soft purring of a simple man falling fast asleep to a bedtime story.

 

Nonetheless, Bill had a tax question and you are, after all, the family’s tax “expert,” so you decide to persevere hoping that, like osmosis, something might seep into his mind over the course of the phone conversation.

Common Law Employees

Under common-law rules, anyone who performs services for Bill is generally an employee, so long as Bill has the ultimate right to control what will be done and how it will be done. This is so even if Bill gives the employee somewhat free reign. What matters, you observe, is that Bill has the right to control the details of how the services are performed. Under these circumstances, it would not matter if Bill called the worker and independent contractor or an employee. The substance of the relationship, not the label, governs the worker’s status. Neither does it matter whether the individual is employed full-time or part-time. As noted in the titled, there is often a razor thin line between employees and independent contractors.

In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories:

  1. behavioral control;
  2. financial control; and
  3. the type of relationship of the parties.

He grunts, which you take as a sigil of approval to continue, and so you do…

Behavioral Control

An employee is generally subject to the business’ instructions about when, where, and how to work. Each of the following are examples of types of instructions about how to do work:

  • When and where to do the work.
  • What tools or equipment to use.
  • What workers to hire or to assist with the work.
  • Where to purchase supplies and services.
  • What work must be performed by a specified individual.
  • What order or sequence to follow when performing work.

Monkey Working WCEven if no instructions are given, sufficient behavioral control may exist if Bill has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals (though you’re not terribly worried about this in the emu-farming context). In other cases (like emu farming), the task may require little or no instruction.

The key consideration is whether Bill has retained the right to control the details of a worker’s performance or whether, instead, Bill has given up that right. Further, an employee may be trained to perform services in a particular manner, whereas independent contractors ordinarily use their own methods. Lord knows that Bill has his own “methods,” and you explain that this factor, therefore, leans heavily towards an employer-employee relationship.

Financial Control

Beyond controlling when, where, and how to work, and employer-employee relationship is more likely to exist than not if Bill has the right to control the “business aspects” of the worker’s job. For instance, an employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission (such as for the number of eggs laid and hatched on the farmhand’s watch).

An independent contractor, however, is often paid a flat fee or on a time and materials basis for the job. In some professions, such as law and ostrich husbandry (you’re told), it is not uncommon to pay independent contractors hourly; thus, this factor alone is not determinative.

Handyman WCIndependent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their employer.

If the worker has a significant investment in the facilities or tools that he or she uses in performing services for someone else, the worker is more likely an independent contractor. Similarly, if the worker uses his or her own tools or facilities in performing the work for a business, it is more likely (but not necessarily determinative) that the worker is an independent contractor than an employee.

A critical factor to look at is the extent to which the worker makes his or her services available to the public. An employee is not generally free to seek other business opportunities (and keep his or her job). On the other hand, an independent contractor is more likely to be able to market himself or herself to others. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market. Nonetheless, certain independent contractors are subject to noncompete agreements or other restrictions against outside employment. Thus, this factor alone is not always determinative.

The final “financial control” factor concerns the extent to which the worker can realize a profit or loss. Generally speaking, an employee is salaried, and though the employee may work towards a bonus, he or she will not share in the profits of the business. On the other hand, an independent contractor is more likely to be able to make a profit (or suffer a loss) depending on the performance of his or her work.

Type of Relationship

Does Bill intend to draw up a written contract that describes the relationship that the parties intend to create? Though not absolutely controlling, such a contract is often determinative if not, at the very least, persuasive to the IRS. If Bill engages the worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that Bill’s intent was to create an employer-employee relationship. Further, if Bill provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay, then it is more likely than not that the relationship will be considered that of an employer and an employee.

Emu Chicks WCIf a worker provides services that are a key aspect of Bill’s regular business activity (i.e., emu farming), it is more likely that he will have the right to direct and control the worker’s activities. For example, if a Bill hires an apprentice fowl-wrangler, it is likely that Bill will train and supervise the worker and teach him the ropes of being one with the emus.

He will likely have the right to control and direct the worker, and the worker will likely depend on Bill’s training so as not to get trampled by a mob of ornery emus. (And yes, a group of emus is called a mob, not a flock. Now you know.) This on-the-job (and life-and-death) training would indicate an employer-employee relationship.

Additional Tests

Counting Fingers WCBefore the three-part test (behavioral control, financial control, and type of relationship) was adopted by the IRS, there was a twenty-part test used by the IRS. (Yes, you read it right, twenty.) Somewhere along the way, an IRS employee, who had lost certain digits due to unfortunate Zima-induced fireworks incident one summer in college down by the lake and could no longer reliably count to twenty using his digits, distilled the twenty factors to the three that we described above. Although not explicitly used anymore, the twenty factors first set forth in Rev. Rul. 87-41 remain instructive; so we’ll look at a few now.

Factors Indicating Employer-Employee Relationship

Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that Bill wants the services performed in a particular method or manner, which suggests that the worker is an employee. When the success or continuation of the emu farm depends, to an appreciable degree, upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by Bill.

Shovel WCIf the services must be rendered personally, presumably Bill is interested in the methods used to accomplish the work as well as in the results. The establishment of set hours of work by Bill is a factor indicating control. A requirement that the worker submit regular or written reports to Bill, likewise, indicates a degree of control. The fact that Bill furnishes shovels, rakes, and other implements of destruction (i.e., significant tools, materials, and other equipment) tends to show the existence of an employer-employee relationship.

If a majority of the work is performed at the emu farm, this factor suggests control over the worker.  This is especially true in situations in which the work could be done elsewhere. On the other hand, if a job must be performed on site (such as a plumber fixing a leaky pipe), this factor may be neutral.

The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer’s premises. Control over the place of work is indicated if Bill has the right to compel the farmhand to travel a designated route, to canvass a territory (or herd emus) within a certain time, or to work at specific places as required.

If a worker must perform services in the order or sequence set by Bill, that factor shows that the worker is not free to follow the worker’s own pattern of work but must follow Bill’s established routines and schedules. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if Bill retains the right to control the order or sequence in which the job is performed.

With respect to profits and losses, a worker who can realize a profit or suffer a loss as a result of the worker’s services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.

Quit WC

Two of the most important factors in determining worker classification are (1) whether the business has the right to discharge the worker; and (2) whether the worker has the right to terminate the business relationship without liability. The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right to discharge the worker is an employer.

An employer exercises control through the threat of dismissal, which causes the worker to obey the employer’s instructions. An independent contractor, on the other hand, cannot be fired so long as the he or she produces a result that meets the contract specifications. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time that he or she wishes—without incurring liability—this factor indicates an employer-employee relationship.

Factors Indicating Independent Contractor Relationship

If the Bill hires, supervises, and (occasionally) pays assistants, these factors generally show control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status.

If the worker must devote substantially full time to emu farming, Bill has implicit control over the amount of time the worker spends working, which, in turn, would restrict the worker from doing other gainful work. An independent contractor, on the other hand, is free to work when and for whom he or she chooses, so long as the job gets done.

Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by on a job-by-job basis or on a straight commission generally indicates that the worker is an independent contractor. If Bill ordinarily pays the worker’s business and/or traveling expenses, the worker will ordinarily be treated as an employee. When an employer holds the purse strings (controls the flow of money), he or she generally retains the right to regulate and direct the worker’s business activities.

If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on Bill for such facilities, which tends to show the existence of an employer-employee relationship.

If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each such person, especially where such persons are part of the same service arrangement (such as would be the case if Bill ran an emu co-op). The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.

What Happens if You Make the Wrong Call?

Whoopsies WCAs evidenced by the multiplicity of factors discussed above, determining whether a worker is an employee or whether the worker is an independent contractor is not a black and white issue—much to Bill’s noisome chagrin. Understanding this, Congress passed Section 530 of the Revenue Act of 1978 that provides relief from federal employment tax obligations if certain statutory requirements are met for businesses (such as Stunning Sheila’s Emu Farm, which was named after Bill’s erstwhile favorite hen, who was allegedly “mean as a treed black snake and dumb as cow manure in February,” both of which, to Bill, were apparently endearing qualities for an emu…though you admittedly don’t understand what makes frozen cow patties dumber than fresh ones…but here we are).

Section 530 is a relief provision that terminates a taxpayer’s employment tax liability with respect to an individual not treated as an employee if three statutory requirements are met:

  1. reporting consistency;
  2. substantive consistency; and
  3. reasonable basis.

Section 530 relief applies to employers in cases involving determinations of employment status, i.e., worker classification cases. Relief applies to all periods under audit and all future periods so long as the requirements of the statute are met. Section 530 provides a permanent cure for an organization’s employment tax liabilities relating to a worker or a particular group of workers. It is not necessary for the business to claim Section 530 relief for it to be applicable. This means that an IRS examiner is required to explore the applicability of Section 530, even if the taxpayer does not raise the issue.

Section 530: Reporting Consistency

Bill must have timely filed the requisite information returns consistent with his treatment of the worker as a non-employee. Thus, if Bill claims that the worker is an independent contractor, he must file all Forms 1099 for the taxable years at issue, and if Bill claims that the worker is an employee, he must file all Forms W-2 for such years. If no information return requirement exists, such as if the “worker” were actually a volunteer, relief will not be denied on the basis that no returns were filed.

Section 530: Substantive Consistency

If Bill or his predecessor, a man who was known to Bill only as “Popcorn” (Exhibit “A” as to why you’ve learned not to ask Bill any more questions than necessary) treated a worker, or a worker holding a substantially similar position, as an employee, Bill will not be eligible for relief if he later treats the worker (or similarly positioned worker) as an independent contractor. The IRS is required to look at all facts and circumstances to determine substantive consistency, including reviewing the day-to-day services performed and comparison of the job functions. The mere fact that two jobs have similar titles or categories is not sufficient grounds for the IRS to deny Section 530 relief.

Section 530: Reasonable Basis

Bill may also “reasonably” rely on one of three “safe harbors.” If Bill had been previously audited, and the IRS determined that a certain worker or group of workers were independent contractors, Bill may rely on this determination during the previous audit to later classify the same worker or group of workers as independent contractors. Importantly, after January 1, 1997, in order to rely on a previous audit, the audit must have included an examination for employment tax purposes of the status of the class of workers at issue or a substantially similar class of workers. None of Bills previous six audits related to worker classification, and so he cannot hang his hat on this rung.

Reasonable WCNext, if Bill relied on judicial precedent to classify a worker or group of workers as independent contractors, reasonable cause will likely be found. The facts in the case must be similar to the situation of the taxpayer at hand, and the judicial precedent or published ruling must have been in existence at the time the taxpayer began treating workers as non-employees. One case is sufficient to establish a precedent that creates a safe haven.

This is true even if case law can be found to support either side of the non-employee/employee issue. Although state court decisions and rulings of agencies other than IRS do not constitute judicial precedent, such reliance may fall under the other reasonable basis safe haven. Nevertheless, it is best not to have to hang your hat on state court precedent. Just because precedent exists, doesn’t mean that Bill can rely on it.  He must have actually known about the precedent to rely on it at the time the classification decision was made.

Finally, if Bill is able to show that it is “industry practice” to classify a worker or group of workers as independent contractors, reasonable cause may be found. Bill would need to show reasonable reliance on a long-standing, recognized practice of a significant segment of its industry. For purposes of this safe harbor, an “industry” generally consists of firms located in the same geographic or metropolitan area which provide the same product or service and compete for the same customers.  For niche businesses like boutique emu farms, the geographical reach would likely have to be expanded somewhat.

For each of these three tests, however, the taxpayer must have relied on the alleged authority at the time the employment decisions were being made for the periods at issue. Section 530 does not allow ex post facto justification.

In addition to these three stated safe harbors, the IRS is permitted to consider other grounds that Bill might present to establish “other reasonable basis.” Importantly, the IRS, in its own publications, states that the reasonable cause exception is to be liberally construed in favor of the taxpayer. Examples of “other reasonable basis” include advice of an attorney or an accountant; state or federal (non-tax) law, or other non-IRS determinations; a prior audit of the predecessor (Popcorn’s) business; a Private Letter Ruling or a Technical Advice Memorandum that was issued to a predecessor (Popcorn’s) business; or the catchall category, “good faith.”  You pause here and explain that nothing you have said to Bill thus far constitutes your official advice.  He snorts, and you continue.

Section 530: Burden of Proof and Consequences of Determination

Ultimately, Uncle Bill bears the initial burden of establishing that it was reasonable not to treat an individual as an employee, and—whether he likes it or not (he won’t)—he must absolutely cooperate fully with reasonable requests from the IRS examiner. If Bill does cooperate fully with the examiner, the burden of proof shifts to the IRS for the reporting consistency requirement, substantive consistency requirement, and the three safe havens. Not to belabor the point, but because it must be said, you explain to Bill that just because it is the IRS making the requests, this does not ipso facto make said requests “unreasonable.”  He says he understands.  You have your doubts.

It’s also important to note that Section 530 Relief does not actually determine whether or not a worker is an independent contractor. Instead, it provides relief from employment tax liabilities for the service recipient (the business/employer), regardless of the IRS’s ultimate determination as to the proper classification of the worker. Thus, even if the IRS tells bill that the worker was, and always has been, an employee, if Bill has a reasonable basis for treating the worker as an independent contractor, the IRS’s determination will not act to deny Section 530 relief.  Furthermore, Section 530 relief extends into perpetuity—unless there is a material change in facts surrounding the relationship. Thus, Bill may continue to report payments on Form 1099; however, if Bill changes to reporting payments to the worker on Form W-2, he will lose the Section 530 relief for future years.

Importantly, Section 530 is only a boon for Bill, not the soon-to-be emu apprentice. This is because Section 530 does not change the status of worker. If the IRS determines that the worker is an employee by other means (such as an SS-8 determination),[1] although the employee will not be liable for self-employment tax, he or she will be liable for the employee’s share of FICA (Medicare) taxes, and his or her expenses will be deducted on Schedule A of Form 1040 and will be subject to the 2% AGI limitation.

Meanwhile, Back at the (Emu) Ranch

Recliner WCYou explain all of this to Uncle Bill.  In your head, his eyes, which have long since glazed over, look like a pair of new emu eggs in the cool Maine moonlight. You clear your throat forcibly a couple of times, and when you hear the rusty springs of his old Barcalounger cursing under his weight as he sits up at attention, you explain that his new emu wrangler should likely be classified as an employee.

You explain further that because Bill will exercise significant behavioral and financial control over the apprentice flightless bird-herder, he satisfies the first two prongs of the IRS’s worker classification test. Though you have your doubts that Bill will provide the new farmhand with “employee-type benefits,” such as insurance, a pension plan, vacation pay, sick pay, the relationship between Bill and his new right-hand man (or left-hand lady) strikes you as ticking more of the boxes in the employee category than in the independent contractor category.

Because Bill is a stickler for raising emus “his way” (which includes serenading the hens when it’s egg-laying time with the dulcet tones of Sinatra and Sammy Davis, Jr. (but never Dean Martin—Bill has his reasons)), his control over what will be done and how it will be done is the ultimate deciding factor in favor of classifying the new fief of Bill’s fowl farm as an employee.

Family WCUncle Bill, always as thankful for free legal services as anyone can be, tells you that he will “take your advice under consideration,” which is Bill’s code for begrudgingly going along with the “hard way” that is “tax compliant” and “required by the law.” Thankful that Bill cannot hear your eyes rolling hard against your eye sockets, you (equally as begrudgingly) tell Bill that you’re always happy to help your mother’s “special” brother, blood is thicker than water, and all that jazz.

As you hang up the phone, you thank your stars that this wasn’t one of Bills more cockamamy schemes to skirt the edges of the law…and just as soon as this thought comes, a sinister and ungainly weight settles in your stomach as you imagine what he is bound to ask you next.

Footnote:

[1] Firms and workers file Form SS-8 to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. Filing a Form SS-8 requesting a “worker status” determination means you or the firm is asking the Service to establish if the services you provide to the firm are those of an employee or an independent contractor. Even if an SS-8 is filed, and the worker is determined to be an employee, Section 530 relief is still available to the business/taxpayer; however, the worker will be subject to FICA taxes and the 2% AGI floor on miscellaneous itemized deductions.

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