Coleman Issues Tax Tip: Determining Worker StatusJ. Grant Coleman
May 15, 2017
One of the more difficult tax issues with which businesses are often confronted is determining whether persons supplying personal services to the business are employees or independent contractors. The IRS has recently issued a tax tip providing some advice and a recent decision adds a potential for increased risk of misclassification.
Classification as an employee or independent contractor gives rise to a number of concerns. Among these is an employer must withhold income taxes and pay social security, Medicare taxes and unemployment taxes on wages paid to an employee, but normally does not have this obligation when paying its independent contractors. In its tax tip, the IRS points out two key elements for business owners to consider when it comes to classifying workers: Control and Relationships.
(1) Control. The control a business has over its worker can determine classification as an employee or independent contractor. If the business controls what work is accomplished and directs how it is to be performed, the business exerts behavioral control. If the business directs or controls financial and other relevant aspects of a worker’s job, it exercises financial control. In either case, that control may require classification as an employee rather than an independent contractor. The IRS notes that the factors indicating control include:
- The extent of the worker’s investment in the facilities or tools used in performing services -- more investment by the worker means a more likely contractor classification.
- The extent to which the worker makes services available to the relevant market -- the more the services are performed for others, the more likely the worker is to be classified as a contractor.
- How the business pays the worker -- payment based on time worked or payment based on jobs performed can indicate classification as an employee or an independent contractor.
- The extent to which the worker can realize a profit or incur a loss -- if the worker is protected from loss and has a fixed profit, the worker is more likely to be classified as an employee.
(2) Relationship. How the employer and worker perceive their relationship also is important in determining a worker’s status.
- Written contracts -- contracts describing the relationship the parties intend to create can indicate employment or contractor status.
- Benefits -- if the business provides the worker with employee-type benefits, such as health insurance or pension plan benefits, employee classification is likely.
- Permanency of the relationship -- a short-term relationship would support contractor status.
- Integral services -- the extent to which the services performed by the worker are a key aspect of the business of the company can be important; the workers performing the basic services that the business conducts are more likely to be classified as employees, while performance of incidental services makes contractor status more likely.
- Business expenses -- if the worker’s expenses are reimbursed, employee classification is more likely.
The tax tip indicates that businesses can get help from the IRS to determine the status of their workers by using Form SS-8.
Characterization as an employee or independent contractor does not have a purely tax impact on a business. Entitlement to benefits provided to employees generally also can turn on this classification. A recent case indicates another potential risk of misclassification. In Derolf, et al v. Risinger Bros. Transfer, Inc., 119 AFTR 2d ¶ 2017-692, an Illinois Federal District Court case, workers for a business claimed misclassification as independent contractors rather than employees and among their claims made an allegation that the business violated IRC §7434 by purposefully misclassifying them and willfully filing fraudulent information returns by issuing them 1099 returns instead of W-2 returns. Under §7434, a recipient of a 1099 has a civil right of action against the issuer of a 1099 which is determined to be willfully fraudulent, and can recover any damages incurred. In this case, the court held that the workers were properly classified as non-employees (and supplied a good analysis of the relevant factors), and further held that, even if they had been improperly classified, the workers did not have a §7434 right of action as such was only available to the recipient of a 1099 where the nature of the fraud pertained to the pecuniary value of the payments at issue -- in other words, the amount paid -- and was not available for misclassification.
In reaching its conclusion regarding §7434, the Derolf court relied on two prior Federal District Court cases, but it should be noted that there is no appellate decision on point. If the appellate courts ultimately decide that actionable fraud under §7434 can include misclassification, there will be additional importance to proper classification.