Independent Contractor or Employee?

The tax rules in this area are a confusing patchwork of common-law rules, Code-based "statutory employee" and "statutory independent contractor" rules, a non-Code relief provision ("Section 530") that essentially overrides the common law rules and the statutory employee rules if its conditions are met, and hundreds of cases and ruling that often turn on the particular facts and circumstances involved. As a result of this myriad assortment of legislative definitions, rules and guidelines, companies often find themselves in the dark when it comes to applying the rules in everyday business practices.

There is no uniform definition of the term "employee" for purposes of the income tax rules.

Under the common-law rules, an individual generally is an employee if the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it. Otherwise, he is an independent contractor.

The IRS has listed twenty factors in Revenue Ruling 87-41 as an aid to determining whether an individual is an employee under the common law rules (whether sufficient control is present to establish an employer-employee relationship.

1. Instructions. A worker who is required to comply with other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions.
2. Training. Training a worker by requiring an experienced employee to work with the worker indicates that the person or persons, for whom the services are performed, want the services performed in a particular method or manner.
3. Integration. Integration of the worker’s services into the business operations generally shows that the worker is subject to direction and control.
4. Services rendered personally. If the services must be rendered personally, presumably the person for whom the services are performed are interested in the methods used to accomplish the work as well as in the results.
5. Hiring and supervision. If the person for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job.
6. Continuing relationship. This factor indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.
7. Set hours of work. The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control.
8. Full-time requirement. If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work.
9. Doing work on employer’s premises. This factor suggests control over the worker, especially if the work could be done elsewhere.
10. Order of sequence of work performed. This factor shows that the worker is not free to follow the worker’s own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed.
11. Oral or written reports. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control.
12. Payment by the hour, week or month. This factor generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job.
13. Payment of business and/or traveling expense. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker’s business activities.
14. Furnishing of tools and materials. This factor tends to show the existence of an employer-employee relationship.
15. Significant investment. Lack of investment in facilities (such as the maintenance of an office rented at fair value from an unrelated party) indicates dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer-employee relationship.
16. Direct interest in profitability of the work accomplished. A worker who can realize a profit or suffer a loss as a result of the worker’s services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee.
17. Working for more than one firm at a time. If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor.
18. Making services available to the general public. The fact that a worker makes his or services available to the general public on a regular and consistent basis indicates an independent contractor relationship.
19. Right to discharge worker. This is a factor indicating that the worker is an employee and the person possessing the right is an employer.
20. Right to terminate the work relationship. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship.

Individuals who are statutory employees are treated as 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 individuals are agent drivers and commission drivers, life insurance salespersons, home workers, and full-time traveling or city salespersons who meet a number of tests. Statutory employees may or may not be employees for non-FICA purposes.

Individuals who are statutory independent contractors (i.e., specifically identified by the Code as being non-employees) are not employees for purposes of wage withholding, FICA or FUTA, and the income tax rules in general. These individuals are qualified real estate agents and direct sellers.

Section 530 of the ’78 Revenue Act (as amended) essentially overrides both the common law rules and the statutory employee rules. It provides retroactive and prospective relief from employment tax liability to employers who misclassified workers as independent contractors.

Section 530 applies only if the employer:

Filed all federal returns consistent with its treatment of a worker as an independent contractor. Relief is not available for any year the employer did not file the required Forms 1099-MISC. If the employer filed the required Forms 1099-MISC for some workers, but not for others, relief is not available for the workers for whom Forms 1099-MISC were not filed.

Treated all similarly situated workers as independent contractors. This requirement applies to the employer and any predecessor business. If the employer treated similar workers as employees, this relief provision is not available.

And, had a "reasonable basis" for not treating the worker as an employee. To establish that the employer had a reasonable basis for not treating the workers as employees, the employer must show that:

a. A court case about Federal taxes or a ruling issued to the employer by the IRS was relied upon; or,

b. The employer’s business was audited by the IRS at a time when similar workers were treated as independent contractors and the IRS did not reclassify those workers as employees; or,

c. The employer treated the workers as independent contractors because it was known that this was how a significant segment of the employer’s industry treated similar workers; or,

d. The employer relied on some other reasonable basis. For example, the employer relied on the advise of a business lawyer or accountant who knew the facts about the employer’s business.

While Section 530 ends the employer’s liability for employment taxes (and any interest or penalties attributable to that liability), it has no effect on workers. It doesn’t convert an individual’s status from "employee" to "self-employed". Although the employer’s obligation to deduct the FICA tax from the employee’s salary is ended, the employee remains liable for the employee share of that tax. Employees who incorrectly paid self-employment tax (because of their mistaken treatment as independent contractors) may file a claim for refund for the difference between the self-employment tax they paid and the employee share of FICA.

A worker, treated as an employee under Section 530, is still an employee for income tax and qualified benefit plan eligibility purposes. As a result, the employer must consider workers treated as employees under Section 530 as employees in determining whether its pension, profit sharing, or stock-bonus plan satisfies the qualification requirements of Code Section 401(a).

Where Section 530 relief is not available, the IRS has established a Classification Settlement Program. The Classification Settlement Program or "CSP" is an optional settlement program that allows businesses and tax examiners to resolve worker classification cases as early in the administrative process as possible. In the CSP, examiners can offer a business under audit a worker classification settlement using a standard closing agreement developed for this purpose. The CSP procedures also ensure that the taxpayer relief provisions under Section 530 of the Revenue Act of 1978 are properly applied.

Taxpayer participation in the CSP is entirely voluntary. A taxpayer declining to accept a settlement offer retains all rights to administrative appeal that exist under the Service’s current IRS procedures and all existing rights to judicial review.

This information was presented for discussion purposes only. For additional information regarding this topic, see Revenue Ruling 87-41, Section 530 of the Revenue Act of 1978, Code Sec 3121(d), 3508(a)(1), and Notice 98-21.