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Independent contractor vs. employee a taxing dilemma.


If given a choice, most employers would prefer to classify a subordinate as an independent contractor rather than an employee. By doing so, the employer reduces costs and increases the bottom line. Payroll taxes (e.g., social security (FICA) and unemployment taxes (FUTA) can be avoided, and workmen's compensation insurance and fringe and other employee benefits need not be provided. Nor are income taxes withheld. As a result, bookkeeping may also be simplified and costs reduced. No such arbitrary choice is permitted, however.

From the worker's perspective, being treated as an independent contractor necessitates providing his or her own insurance and retirement benefits, and also potentially increases the amount of taxes that must be paid. In 1990, social security taxes of 15.30% are due on the first $51,300 of earned income of a taxpayer. If the taxpayer is an employee, the tax is shared equally with the employer (7.65% each). If the taxpayer is an independent contractor with net earnings of $400 or more, he alone assumes the now larger burden of the tax. Prior to 1990, the independent contractor was entitled to a 2% credit against the social security self-employment tax. For example, in 1989, both the employer and the employee contributed 7.51% (15.02% total) for the social security tax, while the independent contractor was subject to a 13.02% tax rate. Starting in 1990, however, the 2% credit has been eliminated, making the independent contractor subject to the full 15.30% rate, although the taxpayer may now take a new deduction equal to 7.65% of net earnings to arrive at the tax.

In an effort to raise revenues and to help ensure the more uniform application of the tax law, the Internal Revenue Service (IRS) has targeted the independent contractor-employee issue for increased audits. As reported in the March/April 1990 edition of the national accounting finn McGladrey and Pullen Client Newsletter, Ideas for your Success, the IRS has assigned 350 agents to track down employers who misclassify employees as independent contractors. This stepped-up effort resulted from a 1989 pilot enforcement project which showed that 90% of employers had misclassified workers as independent contractors. Forms 1099-Misc, required to be issued by employers under Internal Revenue Code (IRC) Section 6041 (a) to nonemployees who perform services worth at least $600 annually, are being tracked to aid in the IRS's effort.

Unfortunately, compliance in correctly classifying subordinates is made more difficult due to the imprecise definition of what constitutes an employee. For social security tax purposes, IRC Section 3121 (d) defines employee to include the following:

1. officers of a corporation

2. individuals having the status of employees under common law rules, and

3. persons such as an agent-driver or commission-driver engaged in distributing meat, vegetable or bakery products, beverages, or laundry services; full-time life insurance salesmen, home workers performing work according to specifications furnished for whom the services are performed; traveling or city salesmen engaged full-time in the solicitation of orders from wholesalers, retailers, contractors, or hotel and restaurant operators for merchandise for resale or supplies for use in business operations, where such person is remunerated for services provided under a contract contemplating that substantially all services are to be provided by such person unless either (a) the person has a substantial investment in facilities used in connection with the performance of such services, or (b) the services are in the nature of a single transaction not part of a continuing relationship with the person for whom the services are performed.

Likewise, for unemployment tax purposes, employees include those subject to the social security tax other than full-time life insurance salesmen and home workers [Section 3306(i)]. For income tax withholding purposes, IRC Section 3401 defines employees to include an officer, employee, or elected official of any federal, state or local government or related agency, as well as an officer of a corporation.

Since most workers do not fall within the specifically mentioned jobs, attention must be focused on the common law's definition of employee. The treasury regulations issued under IRC Sections 3121, 3306, 3401 essentially provide that a common law employer-employee relationship generally exists; "when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished [Treas. Reg. 31.3121(d)-1(c)(2)]. It is sufficient that the employer has the right to direct and control the manner in which the services are performed, regardless of whether the control is actually exercised. Control only as to the result to be accomplished by the work indicates that the subordinate is an independent contractor; how the relationship is described or designated by the employer and worker is irrelevant [Treas. Reg. 31.3121 (d)-1 (a)(3)].

The regulations delineate several factors that are characteristic of an employer - employee relationship. Included are the right to discharge, the furnishing of tools, and the furnishing of a place to work [Treas. Reg. 31.3121 d)-1(c)(2)]. The list of factors has been expanded by various court cases rulings and IRS rulings, as discussed below. Several of these cases have raised the issue of whether "control" continues to be the test for the employer-employee relationship, or whether it is only one factor to be considered when classifying a worker.

Rev. Rul. 87-41. 1987-1 C.B. 297 examines twenty factors considered by both the IRS and courts in resolving the issue. Not all of these factors will apply in every situation. These factors are to be used only as guides, and are to be applied so that the substance of the transaction prevails over its form. The importance of each of the factors depends on the job and the factual situation in which the services are performed.

1. Instructions. One who must comply with another person's instructions about "when, where, and how" to work will usually be classified as an employee. Again, the right to require compliance with instructions is sufficient to meet the control factor.

2. Training. Training a subordinate through correspondence, requiring attendance at meetings, or by assigning another worker to work with such person indicates the person for whom the services are performed exercises some level of control over the manner that the work is performed.

3. Integration. When the business's success or continuance depends appreciably on the performance of particular services, those who perform the services are to a certain degree controlled by the business owner.

4. Services rendered personally. Where the work is to be rendered personally, the person for whom the work is to be performed supposedly is interested in results of the work and how the work is performed. This suggests the existence of an employer-employee relationship.

5. Hiring, Supervising, and Paying Assistants. Control of workers is generally presumed where the person for whom the work is to be performed can hire, supervise, and pay assistants. However, if the worker provides materials and labor in any manner necessary to achieve the ultimate result, then an independent contractor status may exist.

6. Continuing relationship. A worker is generally considered an employee where a continuing relationship exists between the person for whom the work is to be performed and the worker. Such a relationship may exist even though the work is performed at "frequently recurring although irregular intervals".

7. Set hours of work. The establishment of set hours suggests control exists.

8. Full time required. If the subordinate devotes substantially full time to the business, the person for whom the services are performed controls the amount of time the worker spends working. An independent contractor, however, can work when and for whom he chooses.

9. Doing work on employer's premises. Control normally is present where the work is performed on the premises of the one for whom the work is performed. Likewise, control may be present if the person for whom the services are performed has the right to compel the worker to work at specific places.

10. Order or sequence set. If the person for whom the work is to be performed has the right to set the sequence in which the work is to be performed, control presumably exists.

11. Oral or written reports. A degree of control exists where the worker is required to submit regular or written reports to the person for whom the services are performed.

12. Payment by hour, week, month. These payment methods generally suggest an employee-employer relationship; a commission basis or payment by the job indicates an independent contractor relationship.

13. Payment of business and/or traveling expenses. status is ordinarily indicated if the person for whom the services are performed normally pays the worker's business and travel expenses.

14. Furnishing of tools and materials. The furnishing of tools, materials, and other equipment by the person for whom the services are performed indicates an employee-employer relationship.

15. Significant investment. When the worker invests in and uses facilities that are not usually maintained by employees, the worker typically is an independent contractor. A lack of investment in facilities by the worker suggests employee status.

16. Realization of profit or loss. If the worker's realized profit or loss is dependent upon his or her services, the worker is generally an independent contractor.

17. Working for more than one firm at a time. If a worker is able to perform more than a minimal amount of services for multiple firms or unrelated persons at the same time, the worker generally is an independent contractor.

18. Making service available to general public. A worker who offers his or her services to the general public on a regular and consistent basis is generally an independent contractor.

19. Right to discharge. The existence of the right to fire a worker indicates that the worker is an employee. In contrast, an independent contractor will not be fired unless he or she fails to produce a result that meets job specifications.

20. Right to terminate. If the worker may end the relationship with the person for whom the services are performed at any time without incurring liability, the worker is generally an employee.

As a review of these factors suggests, the issue of whether an employee-employer relationship exists must in doubtful cases be determined on a case-by-case basis [Treas. Reg. 31.3121(d)-1 (c)(3)].

Misclassification of an employee as an independent contractor can result in the imposition of penalties on the employer, the nature of which are dependent on whether the misclassification was intentional or not. Where the employer did not intentionally disregard the requirement to deduct and withhold employment taxes, IRC Section 3509 imposes liability. Specifically, if the employer fails both to withhold income tax and the employee's share of social security taxes when required to do so, he or she is liable for withholding taxes equal to 1.5% of all wages paid to the employee. In addition, the employer is liable for employee social security taxes equal to 20% of the employee's share of the tax. These rates double to 3% and 40%, respectively, if the employer did not comply with the Form 1099 filing requirements, except where it can be shown that the failure to comply was due to reasonable cause [IRC Sections 3509(a) and (b)]. The employer is not entitled to recover any of these taxes from the employee, whose liability for the tax is not affected by the assessment against the employer. In addition, the employer is still liable for FUTA taxes and his or her share of FICA taxes. If the misclassification is intentional, more serious penalties can result. For instance, IRC Section 6672 provides that a person who willfully fails to collect, truthfully account for, and pay over any tax when obligated to do so is subject to a penalty, in addition to other penalties imposed by law., equal to 100% of the tax evaded, not collected or due.

Taxpayers in doubt as to how to classify a worker may complete and file with the IRS Form SS-8, Information for use in Determining Whether a Worker is an Employee for Federal Employment Taxes and Income Tax Withholding. In essence, this form walks the employer through the common law elements previously discussed. Given the current sensitivity of this issue, however, it is strongly advisable to first contact the business's tax accountant or counsel for guidance as to how to proceed. The potential for the costly imposition of penalties requires that considerable attention be given to properly classifying workers.
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Author:Davies, Thomas L.
Publication:South Dakota Business Review
Date:Sep 1, 1990
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