Statistics document the abuse of IC status. A two-year IRS study, in which 1,196 payers were audited, revealed that over 90% of them owed additional taxes. In response, the IRS launched a significant effort to audit this area in 1988. Over 300 collection officers are auditing hundreds of small firms. Currently, the IRS is ascertaining whether Form 1099 documents can be used to identify employees who are misclassified as ICs; IC status is now a high exposure audit area.

Although classification as JC or employee is subjective and often changed at various levels of judicial appeal, IRS reclassification to employee status cannot only require payment of back employment taxes, but also can jeopardize qualified plans (due to discrimination) and result in severe penalties.

This article: 1) discusses the statutory classification of workers as employees or ICs; 2) evaluates the more subjective common law factors of such a classification; and 3) reviews the possible relief provisions and penalties for misclassification.

Statutory Classification as Employee

In only a few instances are workers statutorily classified as employees. For income tax withholding purposes under Sec. 3401(c), an employee includes an officer, employee, or elected official of the U.S., a state, or any political subdivision thereof, or the District of Columbia, or any agency or instrumentality of any one or more of the foregoing. Under the regulations for Sec. 31.3401(c)-1, generally, a corporate officer is an employee, unless the officer does not perform any services or performs only minor services and neither receives nor is entitled to receive directly or indirectly, any remuneration.

For social security tax purposes under Sec. 3121(d), employees include corporate officers and common law employees (discussed later). Additionally, the following individuals who are remunerated for services under a contract, personally perform substantially all of the services, and do not have a substantial investment in the facilities needed to provide the services, are employees: 1) an agent-driver or commission- driver engaged in distributing meat, vegetable or bakery products, beverages (other than milk), or laundry or dry-cleaning services, for his or her principal; 2), a full-time life insurance salesperson; 3) a home worker performing work, according to specifications furnished by the person for whom the services are performed, on materials or goods furnished by such person which are required to be returned to such person; and 4) generally, a full-time traveling or city salesperson other than as an agent or commission driver, engaged in the solicitation on behalf of, and the transmission to, his or her principal of orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments for merchandise for resale or supplies for use in their business operations. For federal unemployment tax purposes under Sec. 33061(i), employees include those individuals referred to under Sec. 3121(d) other than full-time life insurance salesmen and home workers.

Statutory Classification as Independent Contractors

Under Reg. Sec. 31.3401(c)-1(c) generally, physicians, lawyers, dentists, veterinarians, contractors, subcontractors, public stenographers, auctioneers, and others who follow an independent trade, business, or profession, in which they offer their services to the public, are not employees. A director of a corporation is an independent contractor. Also, if certain conditions are satisfied under Sec. 3508, qualified real estate agents and direct sellers are independent contractors.

A qualified real estate agent is a salesperson who is a licensed real estate agent. A direct seller is engaged in the trade or business of selling consumer products to any buyer on a buy-sell or deposit- commission basis for resale in the home or otherwise than in a permanent retail establishment. For either individual, substantially all of their remuneration must be directly related to sales or other output rather than to the number of hours worked, and the services must be performed pursuant to a written contract which states that the individual will not be treated as an employee for federal tax purposes. For example, individuals who sell Mary Kay or Avon cosmetics or Tupperware are usually direct sellers.

Common Law Employees

As reviewed above, few individuals are statutorily classified as employees or ICs. Therefore, most payers must evaluate many subjective factors to determine an appropriate classification.

Under Reg. Sec. 31.3401(c), generally, the relationship of employer and employee 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. That is, an employee is subject to the will and control of the employer not only as to what shall be done, but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he 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 by the work and not as to the means and methods for accomplishing the result, he is not an employee. Whether the relationship of employer and employee exists will in doubtful cases be determined upon an examination of the particular facts of each case.

In Rev. Rul. 87-41 (1987-1 CB 296), the IRS identified 20 factors to indicate whether sufficient control is present to establish an employer- employee relationship. Although not classified as such in the ruling, these factors are based on the worker's investment in the "business," qualifications, services to be provided, work location and time, responsibilities during the assignment, compensation and rewards, and job security. In Exhibit 1, these factors are compared for employees and independent contractors and are further explained below.

Worker's Investment in the "Business"

Typically, employers provide employees with facilities, tools, materials, and other equipment. When the worker invests in these assets, lesser dependence is placed on the payer and tends to indicate IC status.

Qualifications

Typically, employers provide employees with training in the form of close supervision, correspondence with the worker, meetings, etc., to ensure completion of a job in a particular method or manner.

Nature of Services Provided

Typically, ICs provide services to the public on a regular and consistent basis and perform services for many unrelated persons or firms simultaneously. An IC's firm is usually contracted to provide services; there is no requirement for the IC to provide their service personally. Often, upon completion of the job, the relationship ceases. The IC's services are not integrated into the payer's business operations (i.e., the success or continuation of the business does not depend to an appreciable degree on the IC's services). In comparison, employees do not provide services to the public, but usually perform services, which are integrated into the business, on a personal basis to one firm (or a number of firms under the same service agreement) over a continuing period.

Work Location and Time

Usually, employers require work to be performed on their premises, which suggests an element of control over the employee. Additionally, employers have the right to compel an employee to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required. Such control is not exercised over ICs.

Employers set the hours of work and require employees to work full- time. ICs are not restricted from doing other gainful work at times they desire.

Responsibilities During Assignment

Employers hire, supervise, and pay employees to perform services. Employers have the right: 1) to require compliance with instructions about when, where, and how an assignment is to be completed; 2) to set the order/sequence or routines/schedules for employee assignments; and 3) to require submission of regular or written reports about services performed. Conversely, ICs usually hire, supervise, and pay other assistants. ICs are not required to comply with payer instructions about when, where, and how to complete an assignment or to provide regular or written reports. They establish their own work routines and schedules and are responsible only for the attainment of a result.

Compensation and Rewards

Typically, ICs are paid by the job or straight commission, although periodic payments may be made to satisfy a lump-sum fee. They are required to pay their own business and travel expenses and, thus, can realize a profit or loss from services and subject themselves to a real risk of economic loss due to significant investments or liabilities for expenses. Because employers usually pay employees by the hour, week, or month, and pay for their business and travel expenses, employees are not exposed to an economic loss. Since employees do not have a significant investment in a business or its related liabilities, they limit their loss exposure.

Job Security

Employers generally have the right to discharge employees. The threat of dismissal can cause the employee to obey an employer's instructions. ICs cannot be fired so long as they produce a result that meets contract specifications. Termination of services for other reasons may result in liability to the payer.

As noted, the application of these factors is subject to interpretation. This fact is highlighted by the extensive number of revenue rulings and court cases that deal with this issue for individuals in diverse occupations. Pursuant to Reg. Sec. 31.3401(c)- 1(d), whether the relationship of employer and employee exists will in doubtful cases be determined upon an examination of the particular facts of each case. No one factor is controlling and the entire circumstances must be viewed, according to U.S. v. Silk 331 U.S. 704, 67 S. Ct. 1463, 91 L. Ed. 1757 (1947). Therefore, the mere presence of a certain number of factors is not sufficient to classify a worker as an employee or an IC. According to Rev. Rul. 87-41, The degree of importance of each factor varies depending upon the occupation and the factual context in which the services are performed. Therefore, no useful purpose would be served by an exhaustive review of the many factors considered in other cases. Each case must stand on its own facts. In the final analysis, it is the degree of control exercised by the taxpayer that is determinative, not only as to what is done, but also as to how it is done Lifetime Siding, Inc. v. U.S., 359 F. 2d 657 (2D Cir. 1966). The following two cases illustrate the application of these principles.

The facts of Rev. Rul. 74-412 (1974-2 CB 332) refer to an architect. A company, which offers its services to the public, entered into an oral agreement with an individual who was to provide services. A separate agreement with the individual was usually consummated for each project assigned to him. The individual performed the services personally, on the company's premises, and under the company's name. The company furnished an office, desk, materials, secretarial and telephone service and did not charge for their use. The individual, who used his own calculator, instruments, and research materials, was free to accept or decline any project. Compensation was related to the difficulty and estimated time required to complete the job. Periodic progress billings were acceptable, and the company agreed to reimburse the individual for all travel and direct material expenses incurred in the performance of services. Sick pay and bonuses were not available to the individual. The agreement could be terminated by either party at any time, in which event the individual would receive payment for the work performed on each project. The company had ultimate responsibility for timely completion of the job.

The working arrangement accounted for approximately 85% of the individual's working time. Although he was free to solicit similar work from the public for the remainder of his working time, he did not advertise. He was not required to observe the regular working hours of the company or to work a specified number of hours a day or week. The individual received verbal instructions regarding the services to be performed. Since the individual was highly trained and qualified, his activities were informally supervised based on the complexity of the project.

Obviously, this case contains numerous elements of both an employee and an IC, which can lead to conflicting conclusions. However, the IRS ruled that the individual was an employee because the individual performed personal services (services rendered personally) in an office provided by the company on its business premises (no significant investment in facilities), and that such services were necessary and incident to the business conducted by the company (services integrated into the business operation). The individual was not engaged in an independent enterprise in which he assumed the risk of profit and loss. Since he was a skilled worker, he did not require constant supervision. However, the company retained the right to supervise him (supervisory responsibility for company) to the extent necessary for the successful completion of the project (right to require compliance with instructions). In essence, these factors, used as guidelines only, established that the company has the right to control and direct the individual who performed the services, not only as to the result but also as to the details and means by which that result was accomplished.

In contrast to this example, the U.S. District Court case of M.H. Jones v. U.S.A. (CCH 76-2 USTC 9607), illustrates the facts of an independent contractor. Jones, who owned and leased service stations to operators, sold gasoline and diesel fuel to them on consignment at a stated price per gallon. Overwhelmingly, the court found that the operators were independent contractors because Jones did not have the right to control their activities. THe operators determined their own working schedule and set their own prices. They were not required to devote full time to operating the stations and were free to close the stations at any time. They had an opportunity for profit and a substantial investment in merchandise inventory and equipment. They secured licenses and advertised in their own names. They were free to make alterations to the premises and were not required to maintain the premises in an approved manner. The business was conducted free of supervision from Jones. They granted discounts and extended credit at their own risk, hired assistants and paid employment taxes, and considered themselves to be independent businesspeople. They paid income and self-employment taxes as such.

Relief Provisions

Because of the potential for incorrect worker classification and its resultant severe penalties, Congress added Sec. 530 (a non-Code section) in the Revenue Act of 1978 to serve as a relief provision for misclassification. Unfortunately, its usefulness was eroded in TRA 86 when the provision was no longer extended to certain technical service personnel (i.e., an individual who, pursuant to an arrangement between the taxpayer and another person, provides services for such other person as an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work).

To obtain relief, a payer must have a "reasonable basis" for not treating a worker as an employee and must file all required federal tax returns (including information returns) on a basis consistent with the treatment of the worker as an IC. The payer and any predecessor must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977.

To establish a reasonable basis, the payer must prove reliance on: 1) judicial precedent, published rulings, technical advices with respect to the taxpayer, or a letter ruling to the taxpayer; 2) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment for employment tax purposes of the individuals holding positions substantially similar to the position held by this individual; or 3) long-standing recognized practice of a significant segment of the industry in which such individual was engaged. Without some form of IRS intervention (i.e., tests 1 or 2), it appears unlikely that the relief provision would be viable. It is highly improbable that a payer will be able to obtain evidence to document recognized industry practices, since other firms are unlikely to divulge their worker classifications for fear of IRS audit of their practices. Under Rev. Proc. 85-18 (1985-1 CB 518), if one of these three "safe havens" is not satisfied, a payer may still be entitled to relief if the payer can demonstrate, in some other manner, a reasonable basis for not treating the individual as an employee.

After 1987, relief is unavailable to technical service personnel engaged in a three-party situation, i.e., where a payer contracts a technical service worker to provide services to a client. In these situations, the common law factors are controlling. For example, if a payer contracts with a computer consultant to provide services to a client for a one-year engagement, supervises and pays the consultant, an employer-employee relationship is likely to exist. However, assume a firm refers the consultant to a client and obtains only a commission from the client. The worker provides services to the client free of client control. In this instance, the worker is an IC. Rev. Rul. 87-14 provides illustrations about these three-party situations.

Relief remains available to technical service personnel engaged in a two-party situation in which the worker provides services to a client and no third party is involved.

Misclassification Penalties

If the IRS determines that an IC should be classified as an employee, penalties can be severe. Under Sec. 6501, generally, assessment must be made within the three-year statute of limitations. However, if employment tax returns are not filed (a distinct possibility if employees were misclassified as ICs) or are filed fraudulently or with willful attempt to defeat or evade taxes, there is no statute of limitations.

The penalties for employment taxes are summarized in Exhibit 2. Generally, if the failure to withhold is unintentional and the employer does not withhold any income or FICA taxes, the employer and employee consequences are stipulated in Sec. 3509. However, if intentional misstatements are determined, Secs. 3402, 3403, and 6521 control.

If the employer fails to withhold unintentionally and meets the Form 1099-MISC reporting requirements for ICs, the employer must remit 1.5% of wages paid to the employee to satisfy employee federal income tax (FIT) and 20% of the employee's share of FICA to satisfy employee FICA, neither of which are recoverable from the employee. Also, the employer is responsible for FUTA and the employer's portion of FICA.

For example, if the IRS reclassifies Mr. Smith's $25,000 in IC compensation for 1989 as employee salary, the liability of his employer for additional taxes is computed as follows:

Employer FICA ($25,000 x .0751) $1,878 Employer FUTA (7,000 max x .062) 434 Employee FIT (25,000 x .15) 375 Employee FICA (1,878 x .20) 376 Total $3,063

If the employer fails to file Form 1099-MISC other than for reasonable cause, the employee's remittance percentages are doubled, that is, 3% for FIT and 40% for FICA.

In these unintentional cases, the employee has no additional tax liability if compensation is reported as IC income and subjected to self-employment (SE) tax. Since the SE tax exceeds the employee's portion of FICA, the employee is entitled to a refund. However, if income and SE tax are not paid on the IC compensation, the employee is liable for FIT and the employee's portion of FICA.

When the failure to withhold FIT and FICA taxes is intentional or when the employer withholds only FIT but not FICA, all employer (FICA/FUTA) and employee (FICA/FIT) taxes must be paid by the employer. In the unlikely event that employees are located and certify on Form 4669 that they paid FIT, the employer is relieved of this liability. Similarly, if the employee paid SE tax and cannot obtain a refund due to the statute of limitations, an employer remittance is unnecessary. If the employee paid taxes as an IC, no refund is available for FIT; however, a SE tax refund for the SE tax in excess of the employee's FICA is available within the statute of limitations.

In addition to remittance for these employment taxes, employers must be concerned with a possible 100% penalty of taxes due for willful failure to collect or account for and pay over the employment taxes (Sec. 6672), and other penalties for negligence (Sec. 6653), fraud (Sec. 6653), and failure to make deposits (Sec. 6656). Of course, interest can be assessed under Sec. 6621.

Conclusion

With the obvious subjectivity in the law and the possibility of harsh penalties, payers should be careful about classifying workers who as ICs do not clearly meet the criteria. An IRS opinion on a worker's status can be obtained by filing Form SS-8, "Information for Use in Determining Whether a Worker is an Employee for Federal Employment Taxes and Income Tax Withholding." Filing for a request about a presently classified IC may be unwise, since an IRS determination of employee status may trigger an audit. With the IRS scrutinizing this area, conservatism may be the best action.