IRS ramps up action on classification of employees as "independent contractor" or employee.
With the huge rise of the newly self-employed, whether the part timers working through apps like Uber or the millions using websites like UpWork, the freedom of choice in work environments has changed. The IRS is watching these trends as well, since the use of independent contractors will decrease the payroll and Social Security taxes paid into the treasury.
According to the IRS, an estimated 80% of workers are classified as “independent contractors” when they are in fact employees. While I am sure many accountants, lawyers and small business owners would argue with this estimate, the IRS and Department of Labor are building up their enforcement by adding new auditors focused specifically on targeting these misclassifications.
The following is part of the 20-factor control test the IRS uses when questioning a job classification. The importance of each factor varies depending on the kind of work being done. Lack of control isn’t necessarily shown if an employer allows a worker freedom of action.
1) Instructions: A worker who must comply with instructions about when, where and how to work is considered an employee. An employer has control in this area if he/she has the right to require compliance with instructions.
2) Training: Independent contractors ordinarily use their own methods and receive no training from their customers about how to do the job. On the other hand, training given to the worker by the employer usually shows employee status.
3) Integration: Employee status is often shown when a worker’s services are integrated into the business’s operations and the success of the business depends on the performance of those services. This factor may work against supporting independent contractor status in nearly every situation—it’s very difficult to establish whether or not the success of a business would depend on the worker’s contribution to an overall effort.
4) Services rendered personally: A business that requires the worker to personally perform the services shows that the business is interested in the methods used to accomplish the tasks. This, then, shows control by the employer.
5) Hiring assistants: If a worker hires, pays and supervises assistants to complete a contract that requires the worker to supply materials and labor and be responsible for the result, then the worker is independent. When the employer hires, supervises and pays assistants to help the worker, employee status is indicated for the worker.
6) Continuing relationship: An employer–employee relationship is indicated if there is an ongoing relationship between the employer and the worker. This kind of relationship often exists when work is performed at frequently recurring (although irregular) intervals.
7) Set hours of work: While employees normally have set hours of work, independent contractors set their own hours.
8) Full-time work: Independent contractors work when and for whom they choose, while employees must work full time for a business, with restrictions on the worker being able to work elsewhere.
9) Work done on the premises: Work required to be done on the employer’s premises often indicates control, especially if the work could be done elsewhere. However, control may even be present when a worker performs services in his/her own offices. To pinpoint the importance of this factor, look at the nature of the services being performed. Control over the place of work may be indicated when the business has the right to compel the worker to travel a certain route or work at specific places. The worker should be required to work from his/her own office.
10) Order of sequence set: When the employer sets the order of an employee’s duties, it shows control by the employer.
11) Reports: If a worker must submit reports (oral or written) to the employer to account for his/her actions, control is also shown.
12) Payments: Employee status is shown if a worker is paid by the hour, week, etc. The worker should not be guaranteed a minimum salary nor be offered any fringe benefits. If a drawing account is set up for the worker, the worker should be required to repay any excess drawn from the account over commissions earned. In effect, the job should be paid on a straight commission basis.
13) Payments of expenses: If the employer pays business or travel expenses of the worker, the worker is likely to be classified as an employee.
14) Tools and materials: An employer’s furnishing all the tools and materials to do the job usually shows that an employer–employee relationship is operative.
15) Significant investment: An independent contractor has significant investment in facilities or equipment used to perform services for someone else.
16) Profit or loss: An independent contractor can realize a profit or loss as a result of services performed. For example, a worker who has invested in expensive equipment to do a job runs the risk of incurring a heavy loss from the job. This indicates that the worker is an independent contractor. However, the risk that a worker will not be paid is not sufficient risk to categorically show independent status.
17) Working for more than one business at a time: When a worker performs services for multiple firms at the same time, independent status is indicated.
18) Offers service to the general public: When a worker regularly and consistently makes his/her services available to the general public, he/she is an independent contractor.
19) Right to fire: Whereas an independent contractor can’t be fired as long as he/she produces a result that meets the specifications of the contract, an employee can be fired.
20) Right to quit: The reverse of (19) is true here: an employee can quit a job at any time without incurring liability. However, an independent contractor is responsible to meet the terms of his/her contract.
Related IRS Publications and Forms
- Form SS-8 - Determination of Employee Work Status
- Form 8919 – Uncollected Social Security and Medicare Taxes on Wages
- Form 8952 – Application for Voluntary Classification Settlement Program
- Pub 15 – Employer’s Tax Guide
- Pub 15-A – Employer’s Supplemental Tax Guide
- Pub 334 – Tax Guide for Small Business
- Pub 533 – Self Employment tax
Working from home
Just because an individual works at home does not necessarily make that individual an independent contractor for self-employment tax purposes. Many will fall under the category of statutory employee. Here is a court case (LaVerne VanZant, TC Summary Opinion 2007-195) dealing with the issue. Note: Tax Court summary opinion cases cannot be treated as precedent for any other case. The Tax Court has held that an educational consultant who collected data on schools and collated the data at home using a template provided by the firm that engaged her services qualified as a home worker for statutory employee purposes. Thus, she was exempt from self-employment tax. Several classes of workers are employees for FICA purposes even if they are not subject to an employer’s direction and control (i.e., even if they would not be treated as workers under the common-law rules). These workers, who are commonly referred to as statutory employees because they are specifically classified as employees by the code, include home workers. (Code § 3121(d)(3)(C))
A home worker is a person who:
> Performs work in accordance with specifications provided by the person for whom the work is performed;
> Works on materials or goods furnished by that person; and
> Must return the finished product to that person or to someone designated by that person. (Code § 3121(d)(3)(C))
An individual will not be a statutory employee, however, if the services are performed as a single transaction rather than part of a continuing relationship, or if the individual has a substantial investment in the facilities used in connection with the performance of the services.
Statutory employees are allowed to deduct trade and business expenses in arriving at AGI (above-the-line deductions), while common law employees may only deduct their business expenses as part of miscellaneous itemized deductions, subject to the 2% of AGI limitation.
Misclassifying employees can be expensive to the employer. The IRS has tools to calculate your liability for Social Security, Medicare taxes and federal income tax withholding. In addition, Section 3509 rates are not available if your business intentionally disregards the requirement to withhold taxes from the employee or if withholds income taxes but not Social Security or Medicare taxes.
With these added IRS and Department of Labor enforcement efforts, it is more important than ever, if in doubt, to consult a professional CPA, Enrolled Agent or tax accounting expert to help you navigate through the regulations and standards. The IRS has created a Voluntary Classification Settlement Program to address previous misclassifications.
A simple mistake can be costly.