IRS tests for employee-contractor status
“Is my worker an employee or an independent contractor?” That is a common question asked by business owners.
Employees are more costly to an employer/taxpayer than a contractor because the company must pay its share of Social Security, Medicare, and unemployment taxes, and must provide the employee with fringe and other employment benefits. Contractors, on the other hand, are paid an agreed-upon fee, but the contractor, not the business, is liable for all employment taxes. In addition, there is no paid time off or other employment benefits provided to contractors.
Due to the different tax treatments, the Internal Revenue Service has a vested interest in proper classification. The fundamental question to determine the proper category is whether the employer has the right to control and direct the worker regarding the job and how to do it. A 20-factor control test was developed by the IRS based on common law principles that have evolved in the courts. This control test can be divided into three broad categories: Behavioral control, financial control, and the relationship of the parties. The factors are meant to be a guide to determine if an individual is an employee. It is not conclusive as to corporate officers and does not apply to “statutory” employees.
Among the 20 factors considered for employee status are:
• Requirement to follow employer instructions.
• Ongoing training provided by the employer.
• Worker is supplied with tools, materials, facilities, or equipment.
• Worker does not make his or her services available to the general public on a regular basis.
• The ability of the company to “fire” the worker. In contrast, an independent contractor cannot be fired as long as he or she provides the agreed upon service.
It is worthwhile to take the time to understand the factors because there are strict penalties imposed for misclassification. To encourage employers to properly classify workers going forward, the IRS has created a program called the voluntary classification settlement program (VCSP), to resolve past violations without penalty. It is important to note that this program only pertains to the IRS and does not provide relief for other obligations such as state or workers compensation.
To participate in the VCSP, a taxpayer must have filed, within six months of the due date for the past three years, all required forms 1099 for contractors. A taxpayer, including its parent, subsidiary, or other member of its consolidated group, currently under an IRS or employment tax audit by the federal or state government is ineligible for the program.
Once accepted into the VCSP, the taxpayer agrees to:
• Treat the workers as employees for future tax periods.
• Allow the IRS an extra three years to assess employment taxes starting with the first three calendar years after the agreement begins.
• Treat all identified workers of the same class as employees in the future.
In exchange, the IRS will:
• Limit the liability to 10 percent of the employment taxes, calculated at reduced rates, on compensation paid to the identified workers in the most recently completed tax year.
• Waive all interest and penalties on the employment taxes.
• Not subject the taxpayer to an employment tax audit of prior years regarding the identified classification of workers.
To apply for the VCSP, taxpayers file Form 8952 with the IRS at least 60 days before the date they want to begin treating the workers as employees. The IRS reviews the application and contacts the taxpayer, or its authorized representative, to complete the process. Once accepted into the program, the taxpayer enters into a closing agreement with the IRS at which time full payment is due.
The worker classification affects both the taxpayer and the worker. Therefore the IRS offers a formal process, via IRS Form SS-8, for either or both parties to request determination by the IRS on this matter. There are far reaching consequences, from both within and outside of the Internal Revenue Service, to the determination of worker classification. Before applying for VCSP or making an IRS determination request, competent legal advice is critical for your own protection.
• Michelle DellaMaria is a CPA and Certified Valuation Analyst, with Caufield & Flood Certified Public Accountants in Crystal Lake.