By avoiding labeling their workers as employees, employers also avoid paying minimum wages, overtime, payroll taxes, worker’s compensation, unemployment, Social Security contributions, health benefits, paid leave, 401(k) benefits and unpaid leave under the Federal Family and Medical Leave Act. And workers have some benefits to being considered independent contractors, such as the ability to deduct certain business expenses that are not available to employees, the ability to set up their own retirement plans, and the fact that they are not subject to withholding. Of course, many workers want to be considered employees so they can get the benefits due employees, such as vacation pay, overtime pay and health insurance.
It’s easy for an accountant to make a mistake because there is no bright-line test to judge whether a worker is an employee or an independent contractor. The IRS has used a 20-factor test based on common law principles, which it has also shortened into a three-part test focusing on behavioral control, financial control, and the relationship of the parties. The IRS still uses both tests, and states may follow the federal tests or have their own, more restrictive rules.
“Accountants may be unfamiliar with the distinction, and if the IRS or Department of Labor comes in and disputes the decision to label them as independent contractors, they can land in trouble,” said John Raspante, a CPA and director of risk management for CPA Protector Plan, a division of insurance intermediary Brown & Brown. “The rules are complex, and they are subject to multiple reviews,” he said. “The IRS, the DOL or the state workers’ compensation board can object to the status of a worker. The IRS has been successful in these situations, and the claim against the CPA can be significant.”
“It’s a hot-button issue with the IRS, and the DOL and state workers compensation boards are becoming more involved,” said Edgar Gee, a Knoxville, Tenn.-based CPA who specializes in employee classification issues. “They have agreements to share information. When you settle with one, you think it’s over, but it may be just beginning.”
If a business classifies a worker as an independent contractor and the worker is found to be an employee, the business is responsible for the taxes it failed to withhold, as well as the employee’s share, plus interest and penalties over the years the misclassification was claimed. “With several employees over several years, this can quickly become a nightmare,” said Gee.
For those employers losing sleep over the potential consequences of a misclassification, the IRS still has a Voluntary Classification Settlement Program. The mechanics are simple: The employer files Form 8952, Application for Voluntary Classification Settlement Program, and sends it to the IRS, which does an eligibility check and prepares a closing agreement. The taxpayer signs it and sends it back with the amount owed, and begins prospectively treating the workers in question as employees.
“It allows the employer to pay a reduced fine or penalty if they agree to reclassify and start to withhold and pay tax on a prospective basis,” said Gee. Under the program, the amount owed is just over 1 percent of the wages paid to the reclassified workers for the past year, with no interest or penalties and no admission of guilt.
Gee noted that the prerequisites to filing Form 8952 include consistency in treating the workers and any similar workers as independent contractors, and filing all required 1099s for them in prior years. “These are the first two prongs of the Section 530 safe harbor,” he said. (Section 530 of the Revenue Act of 1978, which is not a part of the Internal Revenue Code, provides a safe harbor for employers. Originally intended as a temporary measure, it was made permanent in 1982.) “The third step is finding a reasonable basis to treat them as independent contractors,” Gee said. “If you’ve met the first two prongs already, it’s pretty certain that you meet the third step, which is having a reasonable basis for treating them as independent contractors.”
To add to the complexity in dealing with the issue, DOL standards, and some state rules, are stricter than IRS rules, Gee observed.
One of the states with its own set of rules is Massachusetts, which adds a particularly burdensome requirement, according to Kenneth Brier, a CPA and partner at Needham, Mass.-based law firm Brier & Ganz LLP.
“Massachusetts is particularly onerous,” he said. “Under Massachusetts law, an independent contractor not only has to meet the federal test, but in addition the worker must not be performing services in an area which is intrinsic to the employer’s own business. For example, if a CPA firm hires accountants on a per diem basis to help during busy season, they are clearly hired to do something intrinsic to the firm’s business. They have to be employees, even if they’re hired for a short term.”
“It can become a confusing mishmash,” he added. “You could have a bona fide independent contractor for federal tax purposes and for Massachusetts tax purposes, but nonetheless an employee for other Massachusetts [purposes] such as wage and hour laws.”
There is risk from a number of areas, said Scott Connolly, head of the employment law group at Waltham, Mass.-based Morse Barnes-Brown Pendleton PC. “The employer should be concerned about misclassification claims from the workers themselves,” he said. “Many service providers want to be classified as independent contractors, but companies run the risk because later there might be disharmony in the relationship. A plaintiff’s counsel might advise the worker that they may have a claim for misclassification. The worker could potentially have a claim for triple the amount at issue, and most rules provide for recovery of attorney fees and costs. That makes these claims very popular for plaintiff-side lawyers.”
Startup companies are vulnerable to misclassification, according to Connolly. “They like to employ independent contractors who would not pass the test,” he said. “The worker may want it that way, and the business perceives it as a less expensive way to start the business. But down the line when they want to sell, investors or potential acquirers who do their due diligence will have a reduced interest in investing or will seek a reduction in the price due to the risk of claims by workers or audits by agencies.”
A helpful case
For employers faced with proving their workers were independent contractors, a recent ruling by the Tax Court might help: Mescallero Apache Tribe v. Commissioner, 148 T.C. No. 11. Where the employer was unable to locate the former workers, the court ruled that such employers can access IRS records of the reclassified workers’ tax returns to ascertain whether the workers themselves had paid income tax on their earnings. Such information is generally confidential, but in a case of first impression, the court ruled that an exception under Code Section 6103(h)(4) applied.
If the worker has paid income tax, the employer’s liability would be reduced by the amount the employee paid. The court noted that one of the factors in worker classification cases is whether or not the workers in question viewed themselves as independent contractors or employees. The fact that they paid taxes would be evidence that they viewed themselves as independent contractors. And, of course, to the extent that they paid taxes, it would absolve the employer from liability on the employee’s income tax withholding, and on a host of other liabilities: FICA, FUTA, workers’ compensation, vacation and sick pay, minimum wage violations, and overtime pay.
Roger Russell is senior editor for tax with Accounting Today, and a tax attorney and a legal and accounting journalist.