Payroll Articles
Employer-Employer Relationships and Independent Contractors
Employee Vs. Independent Contractor
Many of the problems employers have in regard to worker classification arise when determining whether a worker is an Employee or an Independent Contractor. It may be cheaper to use independent contractor in a business than Employees because the taxing and reporting requirements are much less costly than they are for Employees. So long as the Independent Contractor provides the employer with a valid Taxpayer Identification Number, the employer's only obligations are to give the contractor a Form 1099_MISC at the end of the year stating how much the contractor was paid for the services rendered (if the total was over $600) and to send a copy of the form to the Internal Revenue Service.
Social Security and Medicare taxes need not be withheld from an Independent Contractors payments or
matched by the employer. No federal or state unemployment insurance taxes are required, and Employee
benefits do not have to be funded, paid, or administered on their behalf. Because misclassification of workers as Independent Contractors rather than Employees has led to substantial losses in revenue for the federal government and the failure to properly credit earnings for Social Security and unemployment benefit purposes, the IRS has focused more resources on Payroll Tax audits for worker misclassification.
Common Law Test
While there is no uniform definition of an Employee under all payroll laws, most workers can be classified as either Employees or Independent Contractors once the Common Law Test has been applied. The Payroll Tax Law , for example, relies on the Common Law Test in making worker status determinations for the purposes of federal income tax withholding and the withholding and payment of employment (Social Security, Medicare, and federal unemployment) taxes.
Right to control
Under the Common Law Test, if the employer has the right to control what work will be done and how that work will be done, then an employer-Employee relationship exists and the worker is a Common Law Employee. This is true regardless of whether the employer actually exercises the right on a regular basis. However, if an individual is subject to the control or direction of another only as to the results to be accomplished, and not as to the details by which those results are accomplished, the individual would not be an Employee under the common law test. It makes no difference what the worker is called by the employer. An agent or contractor is still an Employee if the employer controls the work to be done.
The IRS has sought to streamline the process for determining whether a worker is an Employee or an Independent Contractor by identifying those factors that most clearly indicate the degree of control or independence in the relationship of the worker and the business. Evidence of the degree of control and independence can be grouped into three general types or categories: behavioral control, financial control, and the type of relationship between the parties.
The Employer-Employee Relationship
Behavioral control: Factors that determine behavioral control, which is the right to direct and control the
details and means by which the worker performs the work to be done, include:
Level of instructions the business gives the worker: Evidence that a worker is subject to detailed
instructions about when, where and how to work tends to show the worker is an Employee. Even
if no such instructions are given, the right to control through instructions may be sufficient evidence of employment status.
Level of training provided to the worker: An employment relationship is indicated where the
business provides periodic or ongoing training regarding particular procedures to be followed
and methods to be used in performing the work. Independent Contractors generally rely on
their own methods.
Financial control: Factors that must be considered when determining whether the business has the right
to direct and control the economic aspects of the worker.s job include:
Whether the worker has unreimbursed business expenses: Independent Contractors are more
likely to have unreimbursed business expenses than Employees. The IRS considers fixed
ongoing costs that are incurred whether or not work is being performed as particularly important.
However, Employees may also have unreimbursed business expenses in connection with their
employment.
- Whether the worker has a substantial investment in the work: While it is not required, Independent Contractors often have a significant financial investment in the facilities they use to perform services for a business.
- Whether the workers services are available to the public: Evidence that the worker offers his or her services to the public at large (e.g., business cards, phone listing, marketing materials) indicates Independent Contractor status, although Employees can work for more than one employer at a time.
- How the worker is paid: Employees generally are paid by the hour, week, or month, while Independent Contractors are usually paid by the job. However, some Independent Contractors, such as lawyers or accountants, are customarily paid by the hour.
- Whether the worker can realize a profit or incur a loss: All this financial evidence helps determine whether a worker has the opportunity to make a profit or suffer a loss. If so, Independent Contractor status is indicated.
Type of relationship: There are several factors that generally indicate how the worker and the busi- ness perceive their relationship to each other and their intent regarding the right to direct and control the manner and means of the worker.s activities. These factors include:
- Whether there is a written agreement: A written contract may indicate the type of relationship the parties intended to create.
- Whether Employee-type benefits are provided: If the business provides the worker with benefits usually provided to Employees, such as paid vacations, health and life insurance, sick pay, or a retirement plan, an employment relationship is indicated.
- The term of the relationship: If a worker is hired with the expectation that the relationship will continue indefinitely rather than for a specific period or project, this is generally evidence that the intent was to create an employment relationship.
- Whether the worker's services are an important aspect of the business.s regular operations: If a worker provides services that make up a key aspect of the entity.s regular business activity, it is likely that the business will have the right to direct and control the worker.s activities.
SOME FACTORS AREN'T IMPORTANT: Because of changes in the realities of the workplace over the years, the IRS has identified several factors which it feels are not important in making worker classification determinations. They include part-time or full-time work, the location of the work, and hours of work. Managers are Employees, too. Federal Payroll Tax laws apply to all levels of Employees, including supervisors, managers, and other executives. A corporation.s officers, as well, are generally covered, unless they perform only minor services and are not entitled to any compensation. Keep in mind, however, that managerial Employees are most likely exempt from coverage under other employment-related laws, such as the Federal Wage-Hour Law and the National Labor Relations Act. Members of a corporation.s Board of Directors are generally not Employees of the corporation.
Length of employment makes no difference. So long as an individual meets the common law test for employment status, a part-time or temporary Employee is covered under the federal Payroll Tax laws. The number of hours or days worked makes no difference.
Reasonable Basis Test
Even though a worker meets the definition of an Employee under the common law test, an employer may
treat a worker as an Independent Contractor exempt from federal Payroll Tax laws if it has a .reasonable
basis. for doing so, as determined by ยง530 of the Revenue Act of 1978.5 The reasonable basis may consist of one or more of the following, as well as any other reasonable basis:
Court decisions, published IRS rulings, IRS technical advice sent to the employer, or a private letter ruling from the IRS indicating that the worker (or workers in similar situations) is not an Employee;
A past IRS audit of the employer (not one of its workers) that did not result in a finding of taxes owed or a penalty attributable to the employer.s treatment of the worker (or workers in similar situations) as an Independent Contractor; or
A longstanding, recognized practice in a significant segment of the employer's industry of treating workers in similar situations as Independent Contractors.
Consistent treatment is a must. In order to take advantage of the safe harbor provided by the reasonable basis test, the employer must treat the worker whose status is in question (and all similarly situated workers) consistently as an Independent Contractor and must file all federal tax and information returns
for the period in question based on that treatment. The treatment must have been consistent since 1978 by
the employer and/or its predecessor.
Audits begun after December 31, 1996 may not be relied on unless they include an employment
classification audit of the worker involved or a similarly situated worker.
In making a "significant segment" determination, the IRS cannot require an employer to show
that more than 25% of its industry treated similarly situated workers as independent contractors.
In making a "longstanding recognized practice" determination, the IRS cannot require the
employer to show the practice continued for more than 10 years or that it was in existence before
1978.
There does not have to be an initial determination that the worker is an Employee under the
Common Law Test before Section 530 can be applied.
If an employer changes its treatment of a worker for employment tax purposes from an independent contractor to an Employee, the employer may still claim Section 530 protection for the periods before the change in treatment.
In determining whether two workers hold substantially similar positions, the IRS must take into
account the relationship between the employer and the workers.