Tax Update #3
Hiring independent contractors seems to be a trend these days. Leading that trend is Amazon, who plans on offering employees up to $10,000 in start-up costs and three months of gross pay to quit their jobs and deliver packages. The intent is to strengthen Amazon’s Delivery Service Partner program, which helps entrepreneurs form their own businesses delivering packages for the online retail giant. This appears to be a win-win situation—Amazon saves on employment taxes, and contractors can deduct ordinary and necessary business expenses and possibly take advantage of the Qualified Business Income (QBI) deduction under IRC Sec. 199A.
Although it sounds good, implementing a plan to hire independent contractors may not be so simple. For decades, worker classification has generated controversy between the IRS and taxpayers. According to the IRS, millions of workers are misclassified as independent contractors, which leads to underreported income and unpaid employment taxes. The problem is bound to get worse as the gig economy continues to grow and employers look for ways to cut their tax bills. With a good understanding of the worker classification rules, you can help clients develop policies and procedures to ensure workers are properly treated as independent contractors for tax purposes.
Rules Driving the Worker Classification Process
The following three rules drive the worker classification process:
Common law control rules.
Statutory worker occupation rules.
Internal Revenue Code Section 530 rules.
The common law control and statutory worker occupation rules are used to classify workers as employees or independent contractors. The Section 530 rules relieve employers of federal payroll tax liability in certain limited instances. Each rule is but one component of the worker classification process, so it’s important you apply all components when identifying independent contractors. This section provides a summary of each set of rules.
Common Law Control Rules. Over the years, courts have developed the concept of common law employees and common law independent contractors. Under this concept, employees are workers over whom the business has the right to legally control and direct in what must be done and how it must be done. On the other hand, independent contractors are workers over whom the business may legally control and direct only what must be done. The business may not control how, when, or where the work is performed. The IRS has taken these concepts and developed a list of factors that it believes most clearly shows the degree of control between the worker and the business. These factors are grouped into the following general categories: behavioral control, financial control, and the type of relationship between the parties.
Classic examples of independent contractors include individual lawyers, doctors, dentists, CPAs, architects, veterinarians, and others offering services to the public. However, any of these may be employees if an employer legally controls both what and how work is done.
Statutory Worker Occupation Rules. The Code’s payroll tax statutes provide certain exceptions to the common law rules of employees and independent contractors. For example, the Federal Insurance Contributions Act (FICA) defines certain full-time life insurance salespersons as statutory employees, irrespective of their status under the common law control rules. The Federal Income Tax Withholding (FITW), Social Security and Medicare (FICA) tax, and Federal Unemployment (FUTA) tax statutes each have their own lists of statutory employee occupations. [See IRC Secs. 3401(c) 3121(d), and 3306(i).] Similarly, FITW defines certain real estate agents and direct sellers as statutory nonemployees (also called statutory independent contractors), irrespective of their status under the common law rules. FICA and FUTA also list these same occupations as statutory nonemployees.
Section 530 Rules. Congress enacted Section 530 of the Revenue Act of 1978 (known as Section 530 relief) as a stopgap measure to minimize the controversy between taxpayers and the IRS regarding the application of the common law control rules until a comprehensive legislative solution could be crafted. The focus of Section 530 was to prevent the IRS from reclassifying workers for payroll tax purposes if the business could prove it had consistently treated the worker as an independent contractor in the past and had a reasonable basis for doing so. If it applies, Section 530 almost always controls the worker classification process for all federal payroll tax purposes. This is true even if the worker might otherwise be an employee under the common law or statutory employee rules.
Caution: Section 530 terminates the employer’s liability for employment taxes, but has no effect on the workers or their standing as employees for other purposes (e.g., qualified plan status or determining if the worker is a full-time employee who must be offered certain health insurance coverage).
Four-step Approach to Worker Classification
While determining whether a worker is an employee or independent contractor sounds easy enough, even a simple application quickly shows this is not the case. All three component rules discussed earlier must be considered and applied for purposes of each federal payroll tax statute. Here is a handy four-step approach to help you do this.
Test for Statutory Nonemployee Occupations. Under all three federal payroll tax statutes, qualified real estate agents and direct sellers are statutory nonemployees (i.e., independent contractors) without exception. If the worker falls into either of these two occupations, no further testing is necessary.
Assess Possible Section 530 Relief. Even though an individual is classified as an employee for some or all payroll tax purposes, he or she may still be treated as independent contractor solely for employment tax purposes under Section 530. It generally overrides both the statutory employee occupations and the common law control rules. A worker doesn’t have to be determined to be a common law employee for Section 530 relief to apply. Therefore, relief can be applied before the statutory employee and common law criteria. In fact, the Internal Revenue Manual instructs IRS agents to apply Section 530 first (IRM 4.23.5.3.1).
Apply the Common Law Control Rules. A worker who is an employee under the common law control rules is treated as such for purposes of all three payroll statutes unless Section 530 relief applies. (See Step 2.) (In this instance, the statutory employee definitions listed in Step 4 don’t apply since, by statute, a common law employee can’t be a statutory employee.) However, a worker who is an independent contractor under the common law control rules may nonetheless be treated as a statutory employee. Because the common law control rules are so extensive, we have provided a checklist in Appendix 1 to help you determine worker classification under those rules.
Test for Statutory Employee Occupations. Each payroll tax statute classifies certain occupations as employees irrespective of their status as independent contractors under the common law control rules. Only a handful of statutory employee occupations exist:
a. FITW—compensated corporate officers.
b. FICA—compensated corporate officers, agent (or commission) drivers, full-time traveling salespersons, full-time life insurance salespersons, and homeworkers.
c. FUTA—compensated corporate officers, agent (or commission) drivers, and full-time traveling salespersons.
In some instances, a worker may be classified as a statutory employee for one or two, but not all, of the payroll tax statutes.
Conclusion
In today’s competitive marketplace, companies are looking for ways to reduce the cost of doing business. Understandably, the opportunity to cut total labor costs by half or more often proves irresistible; hiring independent contractors instead of employees can simply be too good to pass up. However, employers must think twice before doing so because the risks of misclassification are significant.
To help avoid the risks of misclassification, please perform a worker classification self-audit for each worker in question. Most of the work can be performed by company personnel; however, you can step in to answer specific tax questions. Start with our practical, four-step approach and use the checklist in Appendix 1 to analyze particular workers under the common law control test.