Tax Tip: Independent Contractor vs Employee

The IRS is aggressively attempting to reduce the "tax gap," which is the annual shortfall between taxes owed and taxes paid. Employment tax noncompliance is estimated by the IRS to account for approximately $54 billion of the tax gap. Under-reporting of FICA makes up $14 billion; under-reporting of self-employment tax accounts for $39 billion; and under-reporting of unemployment tax accounts for $1 billion in lost revenue.

The IRS entered into agreements with workforce agencies in 29 states to share the results of employment tax examinations. These agreements provide a centralized, uniform means for the IRS and state employment officials to encourage compliance with federal and state employment tax requirements. In addition, for the 2008 through 2010 tax years, the IRS plans to examine 6,000 randomly selected employers' Forms 941, Employer's Quarterly Federal Tax Return.

Because the existing worker classification rules are complex and ambiguous, much uncertainty surrounds their interpretation and application. The lack of a single, definitive test for classifying workers as either employees or independent contractors contributes significantly to the worker classification problem.

Therefore, understanding the difference between an employee and an independent contractor is very important. If you are an employer, you are required to withhold and contribute a matching amount of FICA and Medicare taxes from your employee's income. However, if your workers are independent contractors, you are only required to report payments of $600 or more on a Form 1099-MISC (Miscellaneous Income). Failing to make the right classification could cost you money.

If you have workers who make substantial financial investments in tools, equipment, or a place to work, or undertake some entrepreneurial risks, they are probably independent contractors. However, when you control and direct the workers who perform services for you as to the end result and how it will be accomplished, you are probably involved in an employer-employee relationship.

Unless there is a reasonable basis for treating your employees as independent contractors, failing to withhold income and employment taxes from their wages can result in severe penalties and interest, in addition to the back taxes owed. Of course, penalties for intentional worker misclassifications are harsher than they are for inadvertent mistakes.

Your benefit plan may also be in jeopardy if any eligible employees have been misclassified as independent contractors. Since these employees have been excluded from plan participation, your retirement plan may lose its tax-favored status. The problem is compounded when excluded employees seek restitution for lost benefits not only due to their exclusion from the benefit plan, but also for health coverage and other employee benefits. If you are going to classify an employee as an independent contractor, you must ensure that they truly qualify as an independent contractor under applicable tests.

No single definitive test exists for determining whether a worker is an employee or an independent contractor. The U.S. Department of Labor (DOL) and the IRS apply separate tests, but the primary factor in both is the amount of control the employer wields.

The DOL applies the "economic realities" test. It assesses whether the worker economically depends on the employer for continued employment, based on several factors:

• The extent that the services are integral to the business's practices,
• The worker's investment in facilities and equipment,
• The nature and degree of control the business has over the way the worker performs the work,
• The worker's opportunity to make a profit or incur a loss,
• The requisite level of skill and judgment to perform the work, and
• The expected duration of the working relationship.

The IRS has streamlined its traditional 20-factor test for evaluating who's an independent contractor to now focus on three areas:

1. Behavioral. Does the company control or have the right to control what the worker does and how he or she does it?

2. Financial. Does the company control the business aspects of the worker's job (for example, how the worker is paid, whether expenses are reimbursed, who provides tools or supplies)?

3. Type of relationship. Are written contracts or employee-type benefits involved? Will the relationship continue, and does the work performed constitute a key aspect of the business?

Employers do have a limited safe harbor from employment taxes if they misclassify an employee. The IRS can't recover employment taxes or penalties from an employer who misclassified a worker if the employer had a "reasonable basis" for doing so.

Looking Beyond Labels

The language used when drafting agreements with would-be independent contractors is critical. Merely labeling the document "Independent Contractor Agreement" won't do. Employers must tailor the agreement to address the issue of control. One way is by stating that how the work is performed is up to the worker's discretion. But courts will look at the parties' actual conduct in determining worker status. Your attorney can help.

Since the potential liability is considerable, we feel that it would be beneficial for you to verify that your workers are properly classified. It is also important that your employment tax records are in compliance with IRS guidelines, especially in the event of an audit.