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Employer and employee reporting for statutory employees.

Employer and Employee Reporting for Statutory Employees

The Internal Revenue Service, in Rev. Rul. 90-93, reaffirmed that the employee business expenses of "statutory employees" are not subject to the 2% of adjusted gross income (AGI) floor.(1) Instead, even though statutory employees receive a W-2 form and are subject to FICA taxes, the W-2 income and the related employee business expenses are to be reported on Schedule C before the determination of AGI.

Statutory employees with few itemized deductions are allowed to take their standard deduction in addition to the deduction for their related business expenses. Additionally, since this income has already been subject to employee FICA taxes, it is not subject to the self-employment tax that is applicable to individuals who have independent contractor status. The combination of these benefits makes statutory employee status very attractive from the employee's perspective. Therefore, companies need to be aware of how to determine when a person is a statutory employee as opposed to a common law employee or independent contractor.(2)

While statutory employee status does not appear to include large numbers of individuals, the determination is important to a company for the following reasons:

1. Eligible employees may be

losing the benefit from all or part of

their employee business expenses

by erroneously claiming them as

itemized deductions subject to

the 2% of AGI floor. 2. Employees who think they are

eligible (but do not meet all of

the required qualifications) may

be filing their tax returns

erroneously, making them subject to

interest and penalties. 3. Companies that intend to utilize

statutory employees need to make

sure that the employment

relationship is so structured that it

qualifies for this special tax

treatment. Inadvertent

disqualification can lead to penalties for the

employer and subject employees

to the disallowance of certain

expenses. 4. It is the company's

responsibility to make the correct

determination of the employee's status

and to report this status to the

IRS and to the employee on Form

W-2.

Tax Treatment of an Individual's Business Expenses

Before changes initiated by the Internal Revenue Code of 1986, persons working for companies were classified as either independent contractors, outside salespersons or employees. Independent contractors and outside salespersons were entitled to deduct their unreimbursed business expenses in arriving at AGI whereas employees had to treat their unreimbursed business expenses as itemized deductions (except for travel and transportation expenses which were deductible for AGI). While this did give some advantages to the independent contractors and outside salespersons (in terms of those items depending upon AGI and, in some cases, the additional standard deduction), employees still were able to obtain the tax benefits from their travel and transportation expenses and most of the tax benefits from their business expenses.

In 1986, Congress made several critical changes. First, unreimbursed travel and transportation expenses were reclassified as miscellaneous itemized deductions for taxpayer's with common law employee status. Second, a 2% of AGI limit was imposed on all miscellaneous itemized deductions. While miscellaneous itemized deductions are also comprised of such items as investment expenses, professional tax planning advice and return preparation, etc., this limit caused many employees to lose most, if not all, of the tax benefits they had previously received from their unreimbursed travel, transportation and business expenses.

While the status change for travel and transportation expenses and the limit placed on miscellaneous itemized deductions did provide a lot of revenue to help offset burgeoning budget deficits, it also helped reduce recordkeeping as well as administrative and enforcement costs of the IRS. The IRS had been concerned for years that many employee business expenses had the appearance of voluntary personal expenditures and had appealed to Congress for some effective means to deal with them.(3)

In the TRA of 1986, however, Congress did not tamper with the above-the-line deduction for "reimbursed" business expenses reported on Form 2106. Evidently, the employer's payment was significant reason to believe that the expenses were ordinary, necessary and reasonable. However, the 1987 Form 2106 eliminated the deduction for unreimbursed expenses in the determination of AGI. This change in the method of reporting resulted in the IRS implication that all unreimbursed employee (including statutory employee) business expenses reported on Form 2106 would have to be claimed as miscellaneous itemized deductions subject to the 2% of AGI floor. After this change, the only way business expenses could be deducted in arriving at AGI was to claim them as deductions on schedule C. Since individuals classified as independent contractors reported their income on schedule C, the effect of the 1986 change gave them a significant tax advantage over individuals classified as common law employees. As a result, many persons tried to structure work relationships to qualify for independent contractor status. However, there were attendant disadvantages in that the independent contractor had to pay self-employment taxes and lost many, if not all, of the fringe benefits of being an employee.

However, it was not the intent of Congress to force all taxpayers who do work for others into one of these two restrictive categories. Congress realized that there was a group of taxpayers who had some of the characteristics of employees while not meeting the usual common law rules of employment. This group had legitimate business expenses similar to those of an independent contractor, while still retaining some employee attributes. Hence, Congress created the statutory employee status.(4) Since the IRS reaffirmed that taxpayers who meet the requirements for statutory employee status are allowed to deduct their business expenses before arriving at AGI and also because of the changes in Form 2106, it is now necessary that statutory employees report their income and expenses on schedule C before the net profit or loss is included in the computation of AGI.

Because it is important for companies to identify and structure the statutory employee relationship correctly if they wish to qualify their employees for this status, the rest of this article includes a discussion of how to determine when an employee does qualify for statutory employee status.

Who is a Statutory Employee?

To begin, statutory employee status is not available to any officer of a corporation or any person who has the status of an employee under the usual common law rules that are applied in determining the employer-employee relationship.(5) In the following paragraphs, we examine the two main characteristics of statutory employees.

There are two requirements necessary in order for a taxpayer to be classified as a statutory employee. These requirements are in addition to the absence of a common law employer-employee relationship.(6) The first requirement is that the individual must meet the characteristics of a certain select group of occupations. The second requirement involves the type of relationship that the employee has with the company.(7)

In order to meet the first requirement a statutory employee must fall into one of the following occupations:

1. Full-time life insurance

salespersons. 2. Other full-time salespersons

soliciting orders from retailers,

wholesalers, contractors, or

operators of restaurants, hotels or

other similar establishments for

either merchandise for resale or

supplies used in their businesses. 3. Either a commission-driver or

agent-driver who distributes

beverages (other than milk),

laundry or dry cleaning services,

bakery, meat or vegetable products. 4. "Home workers" who perform

work according to the employer's

specifications using materials or

goods provided by the employer.

It appears that this provision

might include individuals doing

work in the home such as

accounting, paralegal work or word

processing. We believe the IRS

needs to clarify the status of such

home workers.

While belonging to one of the above occupation groups (and not meeting the common law employment rules) is necessary for statutory employee status it is not sufficient in and of itself. In general, the following requirements must also be satisfied in order to qualify for statutory employee status:

1. The work or service contract must

be personally performed by the

statutory employee. In other

words, statutory employees

cannot have the work done by

subcontracting or hiring other

employees. 2. The statutory employee cannot

have a substantial investment in

the facilities used in connection

with the performance of such

work or services (other than in

facilities for transportation).

Using one's own personal

computer or similar item would not

appear to be a substantial

investment in the facilities because

these are also used by common

law employees. 3. The work or services must be

part of a continuing relationship

with the person or company for

whom the work or services are

performed and not in the nature

of a single transaction.

Statutory Employees Cannot be Independent Contractors

The characteristics of statutory employees must distinguish them from the independent contractor status. This is important because, while independent contractors report their income and related expenses on Schedule C similar to statutory employees, independent contractors are subject to self-employment taxes. Also, since independent contractors are not employees, they would not qualify for employer provided fringe benefits.

In general, any individual taxpayer that provides services to others but does not have the characteristics of a common law employee and who is not designated as a statutory employee is an independent contractor. However, Section 3508 specifically provides that certain qualified real estate agents and direct sellers of consumer goods are classified as statutory nonemployees when:

1. Their income is based on output,

such as sales commissions, rather

than hours or other measures of

work effort; and 2. The services are performed

pursuant to a written contract stating

that they are not to be treated as

employees.

Statutory nonemployees are given the same responsibilities and benefits of independent contractors.

Because the correct determination of a workers status is important to companies and individuals, Table 1 summarizes the tax treatment and reporting requirements for these different statuses.

Conclusion

Taxpayers who have been statutory employees in recent years may need to file amended tax returns if they deducted expenses on Schedule A (subject to the 2% limitation) instead of on Schedule C as authorized by Rev. Rul. 90-93. Tax practitioners need to be aware of this change and take corrective action before the statute of limitations runs out on prior years tax returns.

The creation of the statutory employee status should be viewed as a major change in employee taxation. Most importantly, this new status provides a solution to some of the old employee versus independent contractor controversy. With proper planning and structuring, companies may find that statutory employees can enhance the firm, especially as a flexible source of workers capable of adjusting to different workloads.

Footnotes

(1)Rev. Rul. 90-93, IRB 1990-45, p. 4. (2) For a discussion of the common law employee requirements see Regs. Section 31.3121 and Rev. Rul. 87-41, 1987-1 CB 296. (3)For information on the intent of Congress see, Report of the Senate Committee on Finance, TRA o 1986, H.R. 3838, p. 78. (4)Section 3121 (d)(3). (5)Sections 3121 (d)(1) and 3121 (d)(2). (6) Rev. Rul. 87-41, 1987-1 CB 296, identifies the various factors that are considered in assessing common law employee status. (7) Section 3121 (d)(3).

Table 1
 Tax Reporting for Statutory
 Employees and Independent Contractors
 Common-law Statutory Independent
 Employee Employee Contractor (Note 1)
Employer files Form W-2 Form W-2 Form 1099
FICA tax File
withholding Yes Yes Schedule S.E


Income tax
withholding Yes Optional No
Employee reports Form 1040,
income on Line 7 Schedule C Schedule C


Employee reports expenses on Schedule A Schedule C Schedule C

Note 1: Statutory nonemployees (certain real estate agents and direct sellers) are treated as independent contractors.

Gerald E. Whittenburg, PhD, CPA, CMA, is the Peat Marwick/Charles Lamden Tax Professor at the School of Accountancy, San Diego State University. He is a graduate of the Unversity of Houston and is a contributing author to several tax textbooks as well as numerous professional journals.

Carol F. Venable, PhD, is an assistant professor of accounting at the School of Accountancy, San Diego State University. She holds a PhD from the University of Arizona and a Master of Accountancy with an emphasis in taxation. She has contributd to numerous professional journals and is a member of the American Accounting Association.

James E. Williamson, PhD, CPA, is a professor of accounting and taxation at the School of Accountancy, San Diego State University. A graduate of the University of Minnesota, he has contributed to numerous professional journals. He is a member of the American Accounting Association, the National Association of Accountants and the American Institute of Certified Public Accountants.
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Title Annotation:Debits & Credits
Author:Whittenburg, Gerald E.; Venable, Carol F.; Williamson, James E.
Publication:The National Public Accountant
Article Type:Column
Date:Jan 1, 1992
Words:2078
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