Choosing Employee or Independent Contractor Status

by Jeff Beck People who perform services for your business will most likely fall into one of two categories—independent contractors or employees. It is very important for you, as a business owner, not to misclassify these people. If you do, you may experience legal or financial difficulties. Independent contractors differ from employees in two main ways:

• Independent contractors control not only the outcome of a project but also how the job gets done.

Independent contractors control their own economic destiny to a large extent, making decisions and business investments that affect how much profit they'll earn and whether they'll suffer a loss. Typically, a small business hires many independent contractors. Common examples are a lawyer, an accountant, a painter who spruces up your office, or a computer consultant who installs specialized software at your store and teaches employees how to use it. Generally, independent contractors have special skills that you need to call on only sporadically. But sometimes your company may have ongoing needs that can be filled equally well by an employee or an independent contractor. If you weigh both possibilities and conclude that you can save money and reduce paperwork by using an independent contractor rather than an employee, fine. But be sure he or she really qualifies for independent contractor status. GENERALLY, INDEPENDENT CONTRACTORS HAVE SPECIAL SKILLS THAT YOU NEED TO CALL ON ONLY SPORADICALLY. The IRS strongly prefers that workers be treated as employees and not as independent contractors. This is because employers must collect taxes on employee earnings through payroll withholding, assuring that the funds flow quickly and surely to the government. By contrast, an independent contractor receives his or her entire earnings without taxes being withheld and is responsible for paying taxes on those earnings. Contributing to the IRS bias against independent contractor status is a belief that some independent contractors may underreport or even fail to report their earnings, which results in a loss of tax revenue. State tax agencies, as well, tend to discourage businesses from classifying workers as independent contractors. If you classify a worker as an independent contractor when the worker should have been treated as an employee, and the IRS or a state unemployment or labor commissioner's office investigates and rules against you, you can wind up having to pay the taxes that should have been withheld, together with interest and penalties.

THE PROS AND CONS OF INDEPENDENT CONTRACTOR STATUS

If you hire a person as an employee, you assume financial burdens that you don't have if you hire the same person as an independent contractor. For example, you must make an employer's contribution for the worker's Social Security. You're also responsible for withholding federal and state income taxes, and for keeping records and reporting these items to the federal and state governments. Each year, you must send the employee a Form W-2 showing how much he or she earned and how much was withheld. That's not all. As an employer, you must carry workers' compensation insurance for the employee and may have to make payments into an unemployment protection fund. Health insurance, retirement plans, and other fringe benefits may add to the cost. Finally, although not legally required, most employers provide paid vacations and sick leave for employees, further driving up costs. Now, contrast this situation with hiring an independent contractor. When you use an independent contractor, you're not required to withhold taxes from the amount you pay the worker, and you don't have to pay any portion of the worker's Social Security taxes. Your only responsibility is to complete a Form 1099-MISC at the end of the year if you paid the independent contractor $600 or more during the year. The form is sent to the IRS and the employee. By hiring an independent contractor rather than an employee, you normally also save the expense of providing an office or other workspace for the worker and the ongoing expenses of fringe benefits and insurance. Furthermore, if you become unhappy with the person's work, you can turn to another independent contractor without going through the trauma often associated with firing an employee who works each day on your premises. Another benefit of hiring someone as an independent contractor is that your company generally won't be liable for the negligence of the person you hire. If you hire employees, however, you would be liable if, for example, the employee carelessly injured someone while at work. Of course, there are tradeoffs. A business doesn't enjoy as much day-to-day control over the work of an independent contractor. And not having the person always available may also be inconvenient. Furthermore, because an independent contractor must charge enough to cover the costs of doing business and still make a profit, he or she may charge a higher price for services than the hourly rate paid to an employee. And if an independent contractor is injured because of some dangerous situation at your business premises or in a place that you have control over, the independent can sue your business, claiming negligence. By contrast, an employee in the same situation would be limited to the often lower workers' compensation benefits. But if you carry adequate liability insurance to protect you from claims by any injured person who is not an employee, this isn't a significant drawback. Some workers prefer to be treated as independent contractors rather than employees. They like the fact that there's no withholding of taxes because it allows them to enjoy a better cash flow, at least up until the time when they have to pay their own income taxes. Workers may also see benefits in being treated as independent contractors because of the opportunity it affords them to charge a higher rate and to deduct business expenses, including money spent on cars, home offices, travel, and entertainment. On the other hand, some workers prefer employment status that gives them paid vacations, medical care, and other fringe benefits at the employer's expense—and freedom from worry about the paperwork required of people who are in business for themselves.

HOW TO AVOID EMPLOYEE CLASSIFICATION PROBLEMS

Because the IRS is the government agency most likely to challenge your classifying a worker as an independent contractor, we'll focus here on how to stay within the IRS guidelines. Fortunately, a worker who qualifies as an independent contractor under the IRS tests will almost certainly qualify as well under the rules of most state agencies, even though the state rules may be slightly different. It may surprise you to learn that there's no law or court case to precisely guide you in deciding if it's legally safe to treat a worker as an independent contractor for federal tax purposes. In fact, the most authoritative guidance is found in an unlikely place—the manual the IRS uses to train its audit examiners. Fortunately, by following a few basic rules derived from the principles discussed in this manual, you're likely to steer clear of most problems.

The Easy Cases

As a practical matter, you can hire a wide range of independent contractors with virtually no worries about whether they should be treated as employees. These "no sweat" situations involve workers who clearly are in business for themselves, demonstrated by the fact they share most of the following characteristics:

• The worker is available to perform services for many businesses.
• The worker has a fixed base of operations (a commercial or office location, or a room at home) and ongoing business expenses.
• The worker lists the business in the phone book and may also drum up business through newspaper ads, radio commercials, and circulars.
• The worker undertakes a job based on the results the client wants but remains free to decide how to get the job done.
• The worker hires and pays for assistants, as needed.
• The worker has invested significant money in the business for equipment, vehicles, and supplies.
• Depending on how the business goes, the worker may earn a large profit, a small profit, or none at all—perhaps even suffering a loss.
• The worker incurs expenses in doing a job that won't be reimbursed by the client.

Example: It's easy to identify people as independent contractors when they, not the companies that hire them, determine how to do the work that needs to be done. Also, a worker who essentially runs his own business is almost always an independent contractor.

The Tougher Cases

Other workers may be harder to classify as independent contractors. Not infrequently, a worker may be in an ambiguous area where the distinction between an employee and an independent contractor gets fuzzy. While you may see some advantages in treating the worker as an independent contractor, you may at the same time feel nervous about the legal risks involved because any penalties for misclassification will fall squarely on your shoulders and not those of the worker. Example:Often a work arrangement will share some characteristics of an employment relationship and some characteristics of an independent contractor relationship. In such cases predicting whether the IRS will agree with your decision to treat the worker as an independent contractor is difficult. The IRS pronouncements are not exact enough to allow you to accurately predict the outcome. When faced with an ambiguous situation, you have two safe ways to proceed, as well as a third way that involves a measure of risk.

1. Treat the Worker as an Employee If you want to be super safe and avoid any risk that the IRS or another governmental agency will determine that you've mistakenly classified the worker as an independent contractor, follow a policy of always treating the worker as an employee. This will protect you from possible penalties. The problem is that both you and the worker will lose the advantages that can flow from an independent contractor relationship.
2. Require the Worker to Incorporate If you and the worker are both motivated to go the independent contractor route in an ambiguous situation, the way to do it that's virtually as free from problems as hiring the person as an employee is to simply have the worker incorporate. The IRS will almost always treat this as a valid arrangement and accept the fact that the worker isn't your employee, but rather an employee of his or her own corporation. It's legal in every state to form a one-person corporation, and the process can be simple and relatively inexpensive. Here are the details about how this strategy works:
   • The worker forms a corporation under state law and obtains an employer identification number from the IRS.
   • You sign a contract with the corporation under which the corporation agrees to provide specified services for your business.
   • The corporation hires the worker (who owns the corporate shares) as an employee to perform the services required by your contract with the corporation.
   • The corporation bills you as services are performed for your business under the contract.
   • You pay the corporation—not the employee—for the services billed to your business.
   • Each time the corporation issues a paycheck to its employee, the corporation withholds federal income taxes along with the employee's share of Social Security and Medicare taxes.
   • Periodically, the corporation (using its own employer identification number) pays the IRS the withheld taxes along with the employer's share of Social Security and Medicare taxes.
3. Accept a Measure of Risk Suppose the worker's status as an independent contractor is ambiguous, and for one reason or another, the safer courses of action—treating the worker as an employee or requiring the worker to incorporate—are not practical. Then you must recognize that if you move ahead and hire the worker as an independent contractor, you're opening yourself up to some legal risk. One way to reduce the risk is to get professional advice. See a tax expert—a lawyer or accountant who's familiar with the worker classification issues. Another way to reduce the risk is to follow as many of the following suggestions as you can:
   • Sign a contract with the independent contractor that spells out what the responsibilities are for each party and how payment is to be determined for each job. The contract should allow the independent contractor to hire his or her own assistants and to have as much say as possible as to how the work is to be performed.
   • Require the independent contractor to furnish all or most of the tools, equipment, and material needed to complete the job.
   • Avoid a commitment to reimburse the independent contractor for his or her business expenses; if necessary, pay the independent contractor a little more, but have him or her assume that responsibility.
   • If feasible, arrange to pay a flat fee for the work rather than an hourly or weekly rate.
   • Don't provide employee-type benefits such as paid vacation days, health insurance, or retirement plans.
   • Make it clear, preferably in some written form, that the independent contractor is free to offer services to other businesses.
   • Specifically state in your contract that the contractor will carry his or her own insurance, including workers' compensation coverage.
   • Keep a file containing the independent contractor's business card, stationery samples, ads, and employer identification number. These items can help show that the contractor has an established business.

SPECIAL EMPLOYEE CLASSIFICATIONS

In most situations, you can decide whether a worker should be considered an employee or an independent contractor by looking at a specific set of guidelines. Certain workers, however, fall into special categories, and the usual IRS criteria don't apply to them. For example, the federal tax law says that the following workers are automatically treated as employees as far as Social Security taxes, Medicare taxes, and federal unemployment taxes (FUTA) are concerned:

• Officers of corporations who provide service to the corporation
• Food and laundry delivery drivers
• Full-time salespeople who sell goods for resale
• Full-time life insurance agents working mainly for one company
• At-home workers who are supplied with material and given specifications for work to be performed

For these workers, you must withhold the worker's share of Social Security and Medicare taxes, and you must also pay the employer's portion of those taxes. But you may or may not have to withhold income taxes for a statutory employee; it depends on whether the worker qualifies as an employee or independent contractor under the usual IRS guidelines. Federal law also provides that for tax purposes, licensed real estate agents and door-to-door salespeople are generally treated as non-employees, which is another way of saying they're independent contractors. People in these occupations may, however, be treated as employees for the purpose of state payroll taxes and workers' compensation coverage. As a sole proprietor or partner in your own business, you're neither an employee nor an independent contractor. You're responsible for paying your own income tax and Social Security self-employment tax. If you're a shareholder in a corporation but provide services to the corporation, you're generally an employee.

MISCLASSIFYING EMPLOYEES AS INDEPENDENT CONTRACTORS

Small businesses often run up against IRS auditors when they classify workers as independent contractors instead of regular employees. The interests of the businessperson and the IRS are diametrically opposed: the IRS wants to collect employment taxes for as many workers as possible, and the businessperson wants to keep employment taxes at a minimum. It's obvious that a small business can save a bundle by not having workers on the payroll. According to the United States Chamber of Commerce, it costs a business from 20 percent to 33 percent more per worker to treat them as employees for tax purposes. The simple way to do this is to run a one-person (or a husband-and-wife) business, with no outside help. Because this won't work for most businesspeople, some try to be creative in their hiring practices, which can be disastrous.

Penalties for Misclassification

If your business is audited for any reason, the IRS automatically checks for employees that you claimed as independent contractors. Also, special IRS teams search for misclassified workers under the Employment Tax Examination Program (ETE). Typically these ETE audits focus on industries where abuses are suspected to be common. Recent targets include temporary employment agencies, nursing registries, and building contractors. Other businesses can be selected for the ETE simply because they file a lot of 1099 forms for independent contractors. The tax code authorizes the IRS to force the offending business owner to pay all taxes that should have been paid, plus a special penalty that ranges from 12 percent to 35 percent of the tax bill. The Wall Street Journal reported that between 1988 and 1994 the IRS performed more than 11,000 audits of companies using independent contractors. The results: 483,000 reclassifications (independent contractor to employee status) and $751 million in back taxes and penalties. Example: Unfortunately, the IRS is very selective in its enforcement of worker classification rules. It picks on small businesses while major corporations openly flout the worker classification rules. In the tax world, life can seem very unfair.

New IRS Classification Settlement Program

In 1996, with the Classification Settlement Program (CSP), the IRS offered an olive branch to small-business owners charged with misclassifying employees. This is a relatively inexpensive way to settle with the IRS over past misclassification of workers. In order to qualify for this program, a business owner must:

• Have an open case with the IRS at the time, either in an audit or in appeals. (In other words, you can't call up and volunteer for the program. You must have first been selected for audit.)
• Specifically request CSP treatment.
• Have been in compliance with § 530 of the 1978 Revenue Act. (That means you must have filed all tax returns, including 1099 forms showing independent contractor treatment; treated all similarly situated workers as independent contractors; had a reasonable basis for your misclassification, such as reliance on court rulings, an IRS ruling, or written technical advice; had a past audit that resulted in no employment tax liability for workers in positions substantially similar to the workers in question; or acted consistently with a long-standing practice of a significant segment of your industry.)
• If you qualify, you will be offered one of three settlement deals:
  1. Pay no tax assessment for past misclassifications.
  2. Pay the most recent year of taxes for worker classification deficiencies and the IRS will drop demands for assessments for prior years.
  3. Pay 25 percent of the latest audit year deficiency.
  In all cases, you must further agree to classify the workers as employees in the future. The IRS says it will monitor your case for five years to make sure you don't return to your old ways. Which of the three deals you get depends on the judgment of the IRS and your ability to convince the IRS that you acted reasonably but incorrectly in misclassifying workers. Excuses that may work: your reliance on the advice of an attorney or tax pro; industry practice even if not widespread; or your misinterpretation of the eight IRS factors.

Asking the IRS to Classify Your Workers

If you are in doubt as to how to classify a particular worker, you can ask the IRS to determine the worker's status. Just fill out and send in the IRS Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will respond within several months. Think twice before you ask the IRS to classify workers. The IRS is very likely to rule them employees no matter what the circumstances are. And by using this form, you have put yourself on record, which can work against you if you decide not to follow the IRS's determination and are audited.

Appealing a Ruling That You Misclassified Workers

As IRS auditors have a bias towards classifying workers as employees, it shouldn't be a surprise that business owners more times than not lose out at the audit on this issue. Fortunately, just as with any audit issue, you may appeal a misclassification finding. What's more, the IRS allows you to appeal a worker classification issue even before the rest of the audit of your business is complete. (See Rev. Proc. 96-9.) Before you start your appeal, it might be wise to consult a tax pro, who could help you analyze your position. There are four possible grounds for winning your appeal:

1. The IRS didn't properly consider the 8 factors.
2. Under the safe harbor rule, even if the IRS properly classified a worker as an employee, you can claim industry-standard relief in your independent contractor treatment, if you did what 25 percent or more of the other businesses in your industry are doing. (See § 530 of the Revenue Act of 1978.)
3. You can raise the previous-audit defense if you were audited at any time in the past and no IRS challenge was made as to how you classified your workers, assuming you are still in the same line of business with similar workers.
4. If you still can't convince an appeals officer you are right, suggest a settlement based on your written agreement to change your classification of workers to employees in the future if the IRS will drop the challenge for the past years. This future-compliance offer might be accepted if your workers are in a gray area and the appeals officer is concerned that you might win in court.