Considerations in the classification of workers: Schramm decision addresses adjunct professors.
A Critical Distinction
With respect to employment taxes, employees are subject to withholding of Social Security and FICA taxes. Such taxes have generally been paid at the rate of 7.65% by the employee (6.2% for Social Security and 1.45% for Medicare, up to a certain maximum amount) and matched by the employer. Note that the employer can deduct the matching amount for AGI as a trade or business expense.
In contrast, a self-employed individual (e.g., an independent contractor) is subject to self-employment tax (under the Self-Employment Contributions Act). Such tax has generally been at the rate of 15.3%, as self-employed persons pay both the employee and employer portions (on themselves). A self-employed person can deduct one-half of such self employment tax for AGI. Note, however, that this deduction does not, in fact, offset one-half of the additional Social Security and Medicare taxes paid.
The trade or business expenses of a self-employed person are treated as a deduction for AGI. Such deductions provide the dual benefit of reducing the taxable income derived from the trade or business (thus reducing the amount of tax on such income) as well as potentially reducing the amount of other taxes.
The trade or business expenses of an employee that are not reimbursed under an accountable plan are treated as tier 2 itemized deductions. In order for a taxpayer to derive a tax savings from such deductions, a taxpayer must not only itemize deductions, but also must have total tier 2 itemized deductions exceed 2% of his AGI. Only to the extent that the total tier 2 itemized deductions exceed 2% of AGI can they be included in itemized deductions. Note that, as a result, there is generally a reduction in the amount of the tier 2 itemized deductions that can actually be used to save taxes on the return. One way to enable an employee to avoid such treatment is to have the amount be reimbursed by an employer under an accountable plan.
With respect to itemized deductions, the court in Schramm mentioned, among other items, that "itemized deductions may be limited under Section 68 and may have alternative minimum tax implications under Section 56 (b)(1)(A)(i)."
Note that the classification of a worker's status may have other repercussions, as it can impact certain other rights and benefits; for example, eligibility for COBRA (Consolidated Omnibus Budget Reconciliation Act) healthcare benefits; Americans with Disabilities Act protection; Age Discrimination in Employment Act coverage; ERISA (Employee Retirement Income Security Act) benefits; coverage by various other labor laws, such as the Family and Medical Leave Act; and the ability to avail oneself of the EEOC (Equal Employment Opportunity Commission).
A Typical Example
John, an employee, works for ABC Company. Periodically, John must go out of town for business purposes, for which he is not reimbursed. On a recent trip, John incurred deductible costs of $1,500, which he paid out of pocket and for which he was not reimbursed. He has an AGI of $50,000. Assuming that the $1,500 is his only tier 2 itemized deduction (i.e., the $1,500 deductible cost that he incurred, with regard to the business trip), John will be able to include $500 in his itemized deductions. This is calculated by taking $1,500 minus $1,000 ($50,000 AGI x 2% floor) to reach $500. Note that if John does not itemize, he will not derive any tax savings from the deduction. In contrast, if John were self-employed, he would be able to deduct the entire $1,500 for his AGI. Such a deduction could also potentially reduce the amount upon which his Social Security and Medicare taxes would be computed, and possibly increase the availability of certain other deductions impacted by a percentage of AGI. Note that one half of any self-employment tax that John would pay is deductible for AGI.
Schramm: The Search for Worker Classification
Schramm worked for about seven years for NSU as a teacher of online courses. He taught four to 12 online courses a year and was accorded the status of adjunct professor. The contract to teach each course was of a six-week duration. Schramm, like others with this faculty status, had to abide by the following terms and conditions set by the university:
* Sexual harassment policy
* Drug policy
* Conflict of interest policy
* Syllabus for each course, provided by NSU
* Dates for each course, established by NSU
* Times at which the class was to begin and end, determined by NSU
* Website interface, supplied by NSU
* Evaluation of student learning, provided to NSU by the teacher.
Schramm could have control over aspects of certain activities related to his work. For example, he could do the following:
* Prepare a more involved syllabus
* Establish his own work hours
* Work from any location he wished via computer.
The IRS had previously addressed this issue with respect to NSU and found that these types of worker should be classified as common law employees. NSU, in turn, provided adjunct professors with W-2s, thus supporting the position that such workers were considered to be employees. Pursuant to IRC section 3121 (d) (2), an employee is: "any individual., who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee."
In Schramm, the taxpayer petitioned the Tax Court to deduct business expenses as a loss on Schedule C. The court indicated that it would first examine whether the taxpayer was a common law employee, because if an individual is considered as such, he cannot be considered a statutory employee.
In analyzing the worker classification issue, the court noted that common law principles should be used to determine whether a worker is an employee. In making this evaluation, the following facts and circumstances are to be considered relevant:
(1) The degree of control exercised by the principal; (2) which party invests in the work facilities used by the worker; (3) the opportunity of the individual for profit or loss; (4) whether the principal can discharge the individual; (5) whether the work is part of principal's regular business; (6) the permanency of the relationship; (7) the relationship the parties believed they had entered into; and (8) the provision of employee benefits.
With respect to the above factors, the court noted the following:
[T]he inherent nature of petitioner's position as an adjunct professor calls for him to follow an independent approach in teaching his classes. However we believe that NSU either exercised appropriate control over the petitioner or had the authority to exercise such control in a manner sufficient to render him an employee of the university.
Other matters reflecting such control were that the university indicated the text to be used, the topics to be covered, and the length of the course (in terms of times and dates); determined policies; managed the enrollment of the course; and administered the web interface. In addition, Schramm's costs with respect to materials, supplies, and equipment for the course were considered to be insubstantial. The fact that the taxpayer did not have an opportunity for profit or loss also supported the finding of employee status. In this regard, note that the taxpayer lacked the potential risk or reward associated with the conduct of one's own business, as his compensation was fixed. The taxpayer was thus found to be a common law employee.
Of the above factors, the degree of control was viewed as the most significant. According to the court, one need not actually "direct or control the manner in which the services are performed; it is sufficient if the principal has the right to do so." Should the type of job entail independence, a lesser degree of control may still result in a finding of employee status. In this case, NSU was considered to have adequate enough control to be viewed as the principal. Although the worker may have worked at home or elsewhere, that by itself does not result in a finding of independent contractor status.
The following were other factors mentioned by the court that largely militated against an independent contractor status for the taxpayer:
* The taxpayer lacked a substantial investment in computers and supplies.
* The taxpayer lacked a substantial chance for profit or loss, because the amount paid to him was dependent upon the number of classes taught. The court did not consider there to be a chance for the amount paid to change based upon the work provided.
* Although the court could only infer so based upon what was in front it, it noted that NSU could terminate the arrangement (discharge the taxpayer) at its discretion.
* One factor favoring NSU was that the type of work performed was of the type engaged in as its regular businesses; thus, the worker was assumed to be a common law employee.
* The relationship was a continuing one, based on the longevity of the work relationship and the actual work practices of NSU and the teacher, as well as the consistency of their work arrangement.
* There was a past history of work done by the taxpayer, and there was a history of withholding by the employer.
* The fact that NSU offered potential participation in certain benefits (e.g., involvement in life insurance, health insurance, and a retirement plan) was not accorded much weight.
Based on the evidence and the court's conclusions, the court ruled that the worker was, in fact, a common law employee, and on such a basis was not eligible to claim such deductions on Schedule C. Instead, according to the court, "petitioner's claimed business expenses of $2,785.63 must be reported on Schedule A as miscellaneous itemized deductions and, thus are deductible only to the extent that they exceed 2 percent of petitioner's adjusted gross income."
An Ongoing Dispute
The battle over worker classification continues to be a subject of dispute between taxpayers and the IRS. Care must be taken in properly classifying a worker for both the worker and the party for whom the work is performed. A challenge to worker classification status can result in the substantial expenditure of time and cost for the taxpayer, as well as the garnering of undesirable attention even if the case proves successful. If a claim is not successful, significant penalties and interest may potentially be imposed. Taking steps to ensure that a worker is properly classified serves the best interest of both the worker and the party for whom work is performed.
Mark A. Segal, JD, MLT, CPA, is a professor of accounting in the Mitchell College of Business at the University of South Alabama, Mobile, Ala.
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|Title Annotation:||federal taxation; William E. Schramm|
|Author:||Segal, Mark A.|
|Publication:||The CPA Journal|
|Date:||Feb 1, 2012|
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