Corporate Issues:

"Who am why; why am I here?"

This famous line from the 1992 Presidential debates could be the most fundamental question employees ask of their employers during an Internal Revenue Service determination of employee or contractor status.

This article discusses the factors the IRS may use in auditing a business for proper classification of its workers as either independent contractors or employees. This brief discussion on Federal employee-status determination should not be relied upon by any individual or corporate entity, because circumstances and facts differ greatly between persons and companies. This information is not legal advice relevant to your unique circumstances and is not an agreement for representation. Please share the facts of your case or circumstances with us to determine what course of action is best for you -- we'll be happy to try to help.

Independent Contractor v. Employee:

This page focuses on why companies are often tempted to classify an employee as an "independent contractor" and what factors, if met, will allow an employer to correctly avoid paying federal employment taxes to a worker who is a true "independent contractor." The below does not focus on the factors New Jersey uses in making the same determination for state employment taxes. In fact, the IRS may not rely on a state determination of employee status, because the state may use factors different from the IRS.
This article may also be helpful to those persons who work for a company meeting all definitions of an "employee," but who are wrongfully treated as an independent contractor. To such a worker, this could mean the loss of group health insurance, access to retirement plans, or other benefits offered to employees of the company. If a worker is incorrectly treated by his or her employer as an employee, and not an independent contractor, then the worker has lost the ability to deduct unreimbursed business expenses on Schedule C, but can only list them as miscellaneous deductions on an individual 1040 Schedule A subject to the IRS percentage limitations.
The perspective taken below is that of a business which has classified its workers as independent contractors -- a decision which the IRS may then audit.

IRS Guidelines:

Generally, a company must meet the following factors in order for the IRS to agree with the business's determination that it uses independent contractors and not employees:
A) The company must be consistent from its inception or hiring of the contractor -- (i) the company needs to file all required 1099 Forms for reporting consistency, and (ii) the company must treat all workers in similar positions the same for, what the IRS calls, substantive consistency, and
B) The company must show a reasonable basis for treating the worker as an independent contractor by relying on one of the following -- (i) a prior IRS audit, (ii) prior court or hearing case, (iii) an established practice, throughout a significant segment of the industry, or (iv) another reasonable basis.
If a company meets the above tests then the company -- and not the independent contractor -- is relieved of federal employment tax liability under FICA (Federal Insurance Contribution Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding among other tax.

Reasonable Basis:

The second prong, as listed above, presents more interesting tests than the "consistency" test described in section (A) which is rather straightforward. Accordingly, the below focuses on the second prong above in section (B), and specifically, on the area that causes the most conflict of opinion between companies and the IRS -- Industry Practice.
First of all, the business must be able to demonstrate that it is reasonably relying on industry practice to treat a worker as an independent contractor. The company needs to show a historical practice throughout the industry. An "industry" can be city or county wide, or even country-wide, but generally, it may be limited to the businesses within the same geographic area. Second, and concerning the historic or established practice, the IRS will examine whether the practice has existed for ten (10) years. Even if the industry practice cannot be shown to be at least ten years old, the IRS may still decide to review all the current facts and circumstances of the industry. Third, the practice must be proven to run through a significant segment. Revenue Acts and the Small Business Job Protection Act of 1996 provide that twenty-five percent (25%) (excluding the company under audit) is a significant segment of an industry. A very effective way to prove that treating certain workers as independent contractors is an industry practice is to simply ask your corporate peers. Although your own general management knowledge may be good enough for you and your worker, the IRS will be hard pressed to make a contradictory determination if your company can present a formal survey before or immediately upon your retention of the independent contractor. A survey not only show your good faith attempt to comply with IRS rules and regulations, but will also show your reasonable reliance upon your industry practices.

Common Law and Statutory Determinations:

Thankfully, common law (the law that is followed by judges when courts decide cases) eliminates the need to apply any of the factors above by clearly stating that some professionals can only be treated as employees -- they are not independent contractors. Period. This group includes (i) a corporate officer, (ii) a worker who is defined by common law, or statute, to be an employee, (iii) an employee covered under a Social Security Act §218 Agreement, (iv) a full time insurance salesperson, (v) home workers, (vi) traveling salespersons, and (vii) commission drivers.
Generally, before a worker in sections (iv), (v), (vi) or (vii) can be determined an employee, it must be shown that a contact of service states that the work will be personally performed, a continuing relationship exists between the worker and the company, and the worker has no substantial investment in the company facilities.
Corporate officers are specifically named as employees for purposes of the FICA, FUTA and income withholding tax. Nevertheless, an exception exists whereby a company need not face tax liability for its corporate officers as employees. The following factors must both be met: (i) the officer must not perform any services (or only performs minor services), and (ii) the officer is not entitled to receive any remuneration. In this light, evaluate all payments made to officers, such as loans, dividends, or other "creative" distributions which may be determined by the IRS to be compensation for services as an officer and thus -- wages subject to FICA, FUTA and withholding tax.
The below discusses some factors used to eliminate the circular definition of the second group.
A major factor that is used to determine whether a worker is an employee or independent contractor is the amount of control the worker has, or rather, how much control the employer can exert over the worker. Generally, a worker will be viewed as an employee and not an independent contractor when the company has the right to direct and control the performance of the worker's duties. Evaluate whether the company has the right to direct and control the means and details of the work, before the IRS raises the question. In determining the right to direct and control the means and details of the work, consider three things: (i) the relationship between the company and the worker, (ii) behavioral control, and (iii) financial control.
The first two categories concern issues such as whether the worker gets benefits that employees receive, the written intent of the parties in an employment or contractor agreement, how the worker is terminated or discharged, and whether, and how, the worker is trained or instructed in his or her duties.
Concerning the financial control factor, examine whether it's the company, or the worker, that bears the greatest risk for profit or loss. Generally, an independent contractor makes a large financial investment in the relationship and will typically incur expenses such as: supplies, travel, training, advertising, assistant salaries, rent and postage. Although a good independent contractor agreement will provide for the reimbursement of contractor expenses, the IRS will typically examine unreimbursed expenses, because companies usually pay business and travel and other expenses for their employees and independent contractors are more likely to not receive such reimbursement.

Specific Non-Employees:

Finally, there is a group of workers who are specifically determined to be independent contractors under FICA, FUTA and federal income tax withholding. This group includes: qualified real estate agents, direct sellers (including newspaper carriers) and companion sitters (in relationship to the companion sitter agency).

Conclusion:

The above is just a small portion of the law and practice concerning an employer's duty to classify its workers properly and pay the applicable federal employment taxes. Because this area, like most areas of law, is always changing, we'll be happy to help you learn where you, or your company, may fit into the contractor v. employer determination. Please contact us.

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