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Introduction
In an employer/employee relationship, the employer has the right to control and direct the employee. An employee is subject to the will and control of the employer. The employer controls not only what tasks are to be performed, but also how these tasks are to be performed (see Treasury Regulation §31.3401(c)-1(f) and Internal Revenue Code Section (IRC§) 31.3401(c)).
Qualified real estate agents and direct sellers are treated as independent contractors and not as employees (IRC§3508(a)). Statutory employees include certain drivers, life insurance salespersons, those working in the home, etc., and are treated as employees for FICA tax purposes (IRC§3121(d)(3)).
Most of the employee versus self-employed independent contractor controversy arises from the desire of the taxpayer receiving the services to avoid employer payroll taxes and benefits. Many employers try to shirk their responsibility to pay employer payroll taxes by attempting to treat "employees" as though they are "self-employed." The Internal Revenue Service (IRS) aggressively pursues these cases by imposing significant penalties. When the status of a taxpayer is in doubt, the IRS will generally attempt to classify the taxpayer as an employee, a status that maximizes the overall collection of tax revenues.
Specifically, employers are attempting to avoid:
(1) Employer's portion of FICA taxes (at 7.65%),
(2) Employer-paid FUTA (Federal Unemployment Tax Assistance),
(3) Employer-paid SUTA (State Unemployment Tax Assistance),
(4) Workmen's compensation insurance, and
(5) Paperwork and administrative reporting requirements.
In aggregate, employer-paid payroll taxes can easily amount to 25% of gross salary for the employee. This ignores any medical, dental, profit sharing, fringe benefits, or retirement benefits that firms may also provide to their employees.
The best defense against an IRS effort to reclassify personnel as "employees" is to see to it that these taxpayers want to be classified as self-employed. How is this achieved? First, see to it that the facts and circumstances surrounding their relationship to you support their independent contractor status. Second, see to it that these service providers are adequately compensated for their labor. Finally, it may be to your advantage to see to it that they are receiving high-quality professional guidance toward tax minimization.
The first concern is addressed in the 20 factors used by the IRS to determine employee versus self-employed independent contractor status.
20 factors for employee/self-employment status
In arriving at a decision with respect to the status of a taxpayer, the IRS looks at 20 factors, which are listed below. No single factor is used to determine the status of a taxpayer or their relationship to another taxpayer. However, the facts and circumstances surrounding the relationship between two taxpayers are either supported or not supported.
These factors are either present or absent, as follows:
(1) Instruction
(2) Training
(3) Integration of duties
(4) Services rendered personally
(5) Hiring, supervision & paying assistants
(6) Continuing relationship
(7) Established hours of work
(8) Full-time requirement
(9) Working on "employer" premises
(10) Order or sequential nature of tasks
(11) Oral or written reports
(12) Payment by hour/week/month/etc.
(13) Payment of business travel
(14) "Employer" furnished tools or materials
(15) Significant investment
(16) Realization of profit/(loss)
(17) Multiple employers
(18) Service availability to general public
(19) Right to discharge
(20) Right to terminate
Employee/Employer status
The presence of (1) instruction, (2) training, or (3) the integration of duties with those of employees, or (10) the inherent sequential nature of tasks suggests employee status. The presence of (4) personal servitude (e.g., making coffee or picking up dry cleaning for the boss) or responsibilities involving the (5) hiring, training or supervision of others also suggests employee status.
A (6) continuing relationship with (7) established hours of work, and (8) a full-time requirement is typical of an employee. The required submission of (11) oral or written reports, especially when periodic, or (12) periodic payment (by the hour, week or month), and/or (13) the reimbursement of business travel, especially on forms provided by the "employer" also supports employee status.
If one taxpayer (14) provides tools or materials used to complete tasks to another taxpayer, an employer/employee relationship is supported. This is further supported if these items do not require (15) significant investment on the part of the party performing the tasks.
The absence of business risk, or (16) profit or loss, on a job-by-job basis (or otherwise), supports employee status. If the taxpayer performing the services does so for (17) only one other taxpayer and (18) does not provide these or other services to the general public, employee status is suggested.
Employee status is supported by the presence of the right to (19) discharge and/or (20) terminate services, or by the understanding that the provider of services may be subject to discharge or terminated.
Independent contractor/self-employment status
Independent contractors do not require (1) instruction or (2) training. They are contracted to perform services because they possess expertise. Their (3) duties may be integrated with the duties of others and (10) may even be sequential (e.g., and electrician, plumber and carpenter on the construction of a building), but not so significantly that employee status, per se, is necessary.
Self-employed taxpayers are not required to (4) render personal services to the taxpayer hiring them. They are also not required to (5) hire, supervise or pay others, unless they have their own employees. The latter reinforces and supports their status as self-employed independent contractors.
Self-employed taxpayers (7) establish their own working hours, (8) are not required to work a 40-hour week, or (9) perform the work at established premises. However, the nature of the task may require the presence of these elements for the self-employed taxpayer.
Self-employed independent contractors (11) are not required to provide oral or written reports, but may choose to provide information on a billing summary with their own letterhead, etc. They are (12) not paid on regular paydays, but may bill their clients at an hourly rate and be paid at the end-of-the-month or some other regular billing cycle. The self-employed taxpayer may also require (13) reimbursement for business travel, preferably at some pre-determined rate, and upon receipt of a billing statement.
Self-employed taxpayers make (15) significant investments in (14) tools and/or materials used to complete tasks. They do so in anticipation of the (16) realization of a profit or loss. This class of taxpayer provides services to the (18) general public and has (or has the potential for) (17) multiple clients.
The self-employed taxpayer cannot be (19) discharged or (20) terminated, per se, but may not be hired for future assignments if their work proves to be unsatisfactory. This is understood and does not require formalization. Similarly, the self-employed taxpayer does not typically have the right to discharge or terminate the employees of those he is contracted by, unless this is the very nature of the business in which the self-employed independent contractor is involved.
A typical fact pattern
Generally, cases where a firm incorrectly treats an "employee" as an "independent contractor" evolves and comes to the attention of the IRS, as follows:
First, a firm "hires" someone to provide services. The person hired is not able to become gainfully employed elsewhere, and agrees to the terms of the association - to be treated, inappropriately, as an "independent contractor." This agreement is, in effect, under duress.
Second, the employer issues a Form 1099 for the services provided to the firm. Failure to file the Form 1099 results in penalties that are quite independent of the failure to collect and pay employers FICA and payroll taxes. The Form 1099 contains the Social Security number (SSN) of the independent contractor, providing for a matching of what the so-called independent contractor reports as income and what the firm has paid to this individual.
Third, the so-called independent contractor is surprised to receive a notification from the IRS that the amount of income or the classification of income that they reported did not "match" with what the firm reported, independently, to the IRS. They owe additional federal income tax and self-employment taxes. They may or may not receive a similar notification from the state taxing authority.
Fourth, the "independent contractor," now aware of the significance of the self-employment tax and the tax liability that they are subject to, attempts to establish his/her status and an "employee," which would subject the employer to the employer's portion of FICA taxes and allow the employee to avoid the self-employment taxes that would otherwise result. It may take 24 months or so for all of these events or this sequence of events to occur, but, if "profitable" to the IRS, an investigation takes place and the "employer" has risked an audit to identify other "employees" incorrectly classified as "independent contractors" by the employer.
Summary
The best way to ensure the self-employment or independent contractor status of those with whom you contract is to see to it that they want to be classified as self-employed. This suggests that they possess an understanding of the tax savings made possible through independent contractor or self-employment status, as opposed to employee status. Generally, where efforts are made to reclassify a self-employed independent contractor as an employee by the IRS, this effort is one initiated by the "employee." Frequently, this is the result of the failure of the "employee" to provide for estimated tax payments, and is their reaction to the surprise of a high-year-end self-employment and federal income tax liability. Therefore, if you can avoid the incidence of these year-end surprises for those you contract with, you can also minimize your surprises from the IRS.
Perhaps the most important factors in establishing the non-employee or self-employment status of a taxpayer are (1) the provision of billing statements upon contractual task completion and (2) the establishment and maintenance of business cards and billing statements with logo. If those you contract with present you with billing statements and have business cards, business licenses, etc., they are far more likely to be presumed to be self-employed. Of course, all twenty of the above facts and circumstances will be considered to avoid any "shams" or efforts to avoid legal withholding and payroll tax obligations.
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