Employment Tax Audits - Worker Classification Rules

Making the proper determination on whether to treat a worker as an employee or independent contractor can have significant tax implications. A lot of taxpayers feel they can just classify the worker how they want, however there are numerous situations that you need to look at. The following is a law section on a memo I drafted detailing the rules of how to classify a worker. Most of the information can be found in the IRM too:

IRC section 3121(d)(2) of the Internal Revenue Code provides that the term "employee" means any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of employee. See also IRC sections 3401(c) and 3306(i).

 

The question of whether an individual is an independent contractor or employee is one of fact to be determined upon consideration of the facts and application of the law and regulations in a particular case. With certain limited statutory exceptions, the classification of particular workers or classes of workers as employees or independent contractors, for purposes of Federal employment taxes, must be made under common law rules. Guides for determining the existence of a worker's status are found in three substantially similar sections of the Employment Tax Regulations; namely sections 31.3121(d)-1, 31.3306(i)-1, and 31.3401(c)-1 relating to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and federal income tax withholding on wages at source, respectively.

 

Section 31.3121(d)–1(c)(2) of the regulations provides that generally, the relationship of employer and employee exists when the person for whom the services are performed has the right to control and direct the individual who performs the services not only as to the results to be accomplished by the work, but also as to the details and means by which the result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done, but also as to how it shall be done. In this connection, it is not necessary that the employer actually control or direct the manner in which services are performed; it is sufficient if he or she has the right to do so. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished and not as to the means and methods for accomplishing the result, he or she is an independent contractor. Similar language is found in regulation sections 31.3306(i)–1(b) and 31.3401(c)–1(b).

 

In determining whether an individual is an employee under the common law rules, a number of factors have been identified as indicating whether sufficient control is present to establish an employer– employee relationship. These factors have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which services are performed. See Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318 (1992) and Weber v. Commissioner , 103 T.C. 378 (1994), aff'd 60 F.3d 1104 (4th Cir. 1995). See also Breaux and Daigle, Inc. v. U. S.. 900 F.2d 49 C.A.5 (La.),1990. Also see Rev. Rul. 87–41, 1987–1 C.B. 296.

 

Section 3121(d)–1(a)(3) of the regulations provides that if the relationship of an employer and employee exists, the designation or description of the parties as anything other than that of employer and employee is immaterial. Thus, if such relationship exists, it is of no consequence that the employee is designated as a partner, co-adventurer, agent, independent contractor, or the like. Similar language is found in regulation sections 31.3306(i)–l(d) and 31.3401(c)–1(c).

 

Because there are elements of controls as well as autonomy in all cases, regardless of whether an employment relationship or an independent contractor relationship exists, all evidence of both control and lack of control or autonomy must be evaluated in determining whether there is a sufficient degree of control to establish an employment relationship. In doing so, one must examine the relationship of the worker and the business. Facts which illustrate whether there is a right to direct or control how the worker performs the specific tasks for which he or she is hired, whether there is a right to direct or control how the business aspects of the worker's activities are conducted, and how the parties perceive their relationship provide evidence of the degree of control and autonomy.

 

Factors which influence if a worker is an independent contractor or an employee include:

 

Behavioral Control:

 

Behavioral control factors establish if an employer can control how a worker performs a task.

 

                       Instructions: Does the worker perform the required services:

                

Instruction focuses on how a job gets done and does not factor in the end result of the job. If a person needs to comply to instructions about, when, where and how he has to work is ordinarily an employee. Not all employees need instructions, such as highly proficient employees. Even with these employees, only the right to enforce instructions matters, not if the employer actually provides instructions. (Rev. Rul. 68-598, 1968-2 C.B. 464; Rev. Rul. 66-381, 1966-2 C.B. 449;   Silverstone et al. v U.S., USTC 66-1 P 9468.)

 

                 Training:

 

Training is when methods, procedures or skills need explanation before they are used to complete a job. This helps complete a job in a particular manner. Factors that highlight training are required meetings, correspondence or experience employees working with inexperienced trainees. This training demonstrates an employer wants control over how a job is done.

 

Financial Control:

 

Financial controls occurs when the company can direct economic aspects of worker’s activities.

                

                 Significant Investment:

                

If an individual has a significant investment in the business, then an independent contractor relationship may exist. The investment must only have substance; it does not need to meet any dollar threshold. This investment is seen in the facilities in which the individual has the investment. A lack of investment in the facilities will show an employee-employer relationship. Facilities are equipment or a work premise. These include machinery and office furniture, but not tools, instruments, clothing, etc.

 

The investment is only a significant factor if it is real, essential and adequate. The investment cannot be in facilities a normal employee will normally maintain for an employer. Rev. Rul. 71-524, 1971-2 C.B. 346,  Avis  Rent  A Car  System,  Inc.  v.  U.S. [74-2 USTC, 9725], 503 F2d 423, 429 (2nd Cir. 1974).

                

                       Unreimbursed Expenses:

 

Unreimbursed expenses is when a worker incurs their own expenses in relationship with the job. Having unreimbursed expenses show the worker has the right to direct and control financial aspects of business operations.

 

Most independent contracts incur business expenses. These expenses are either direct expenses or pro rata portions of several other expense. Typically included in these expenses are tools, equipment, training, advertising, wages for assistants, licensing, certification, supplies, travel, leasing equipment and inventory.

 

An employer furnishing tools, materials, etc for a job tends to show an employee-employer relationship. The control aspects originates in that the employer can determine which tools a worker uses, in what order and how to use the tools. Independent contractors normally have their own tools. This is how the independent contractor may show control. If an employee provides their own tools in an occupation where this is a customary practice, then such a practice does not demonstrate lack of control by the employer. Rev. Rul. 71-524, 1971-2 C.B. 346.

                

When an employer pays business or traveling expenses for a worker, then the worker is an employee. Rev. Rul. 55-144, 1955-1 C.B. 483. 

                

                 Services Available to the Relevant Market:

 

Independent contractors can seek their own business opportunities. Doing so incurs expenses such as advertising and a business location. If a person makes services available for the public, then they are normally an independent contractor. (Rev. Rul. 56-660, 1956-2, C.B. 693).

 

                 Method of Payment:

 

If a worker is compensated hourly, daily, weekly or in such other similar manner is guaranteed a return for the labor performed, then this is generally evidence of an employer-employee relationship. A task for a flat fee, however, tends to show an independent contractor relationship. Rev. Rul. 74-389, 1974-2 C.B. 330.

 

                 Opportunity for Profit or Loss:

 

A worker making decisions that affect his own bottom line indicates the presence of an independent contractor. The ability to affect one’s own bottom line is not present if the only way to affect the amount of money made is by working more or less hours. To the contrary, by only affecting the worker’s bottom line by changing work schedules indicates the presence of an employer/employee relationship. If the person can receive either a profit or loss due to the services he performs, then that person is seen as an independent contractor. Rev. Rul. 70-309, 1970-1 C.B. 199.

 

Relationship of Parties:

 

                         Intent of Parties through Written Contracts:

 

If a contract describes a worker as an independent contractor, then each party had intent for an independent contractor relation. This is not sufficient evidence of the worker’s status. This designation is immaterial and only the substance of the relationship determines the law. Reg. Sec. 31.3121(d)-1(a)(3)

                  

                   Employee Benefits:

                              

Any benefits received by a worker, such as a pension, health insurance, paid sick days can only be provided to employees, not to independent contractors.

 

                   Discharge:

 

It is harder for a company to discharge an employee than it is an independent contractor. This is due to the company being liable for items such as severance pay and notice. Therefore, the inability to discharge a worker shows the worker is more likely an employee. However, the right to discharge shows control over the worker. An independent contractor cannot be discharged unless he produces at a quality less than contractually agreed. Rev. Rul. 75-41, 1975-1, C.B.323.

 

Termination:

 

A worker may terminate his relationship with an employee usually on an easier basis. However, an independent contractor cannot merely terminate a relationship due to a legal obligation to complete the work. Rev. Rul. 70-309, 1970-1, C.B. 199.

 

Business Activity:

 

The services a worker performs and how integral the worker is to the company shows he is a key aspect to the company. This level of integration into the company shows the worker is an employee since he is subject to more direction and control. This test relies on the scope and function of the business and how the worker functions within it. If the company needs to rely on a person for company success, then that company will want more direct control over the individual. U. S. v. Silk 331 U.S. 704 (1947), 1947-2 C.B. 167.

 

Miscellaneous Factors to Consider:

 

                   Continuing Relationship:

 

A permanent relationship between the worker and the company is relevant evidence for an employer-employee relationship. Businesses may engage a worker with the intent of a continuing relationship instead of a specific project. This shows intent of an employee-employer relationship. Continuing relationships are shown through frequent recurring, even if irregular, intervals. U.S. v. Silk, 331 U.S. 704 91947, 1947-2, C.B. 167. 

 

                   Work Hours:

 

If the employee sets hours a worker must work, then there is control over the worker. The workers can no longer work as he sees fit but needs to conform to the employers arrangements. Rev. Rul. 73-591, 1973-2 C.B. 337.

                  

                   Full Time:

 

Working full time for the business shows the employer has control over the worker because he restricts access to the worker from finding other employment.  Rev. Rul. 56-694, 1956-2 C.B. 694.