It is not uncommon for employers to misclassify employees as independent contractors to avoid their withholding and tax responsibilities intentionally or because they are unaware of the laws regarding the issue. Misclassifying a worker can have significant ramifications for both the employer and the worker regarding how much each pays in income, Social Security, and Medicare taxes, among others. Worker misclassification is a perennial issue for the Internal Revenue Service and state taxing authorities because many employers need to classify their workers correctly. This article looks at several issues regarding this matter.
The general distinction, of course, is that an employee is an individual who works under the direction and control of an employer, and an independent contractor is a business owner or contractor who provides services to others.
Whether an individual is, federal and state laws govern an employee or an independent contractor. It has always been a complicated issue at the federal and state levels, and the state and federal guidelines often differ. However, because of the significant payroll tax revenues, the states are generally more aggressive in classifying workers as employees.
In recent years several states, including California, Massachusetts, and New Jersey, have adopted the so-called ABC test, which is a broad means of determining a worker's status as either an employee or a contractor by considering three factors. If a worker passes all three, they are an independent contractor. The tests are:
(A) That the worker is free from the hirer's control and direction, in connection with the performance of the work, both under the contract for the performance of such work and, in fact;
(B) That the worker performs work outside the usual course of the hiring entity's business; and
(C) That the worker is customarily engaged in an independently established trade, occupation, or business of the exact nature as the work performed for the hiring entity.
To determine whether a worker is an independent contractor or an employee, the IRS examines the relationship between the worker and the business and considers all evidence regarding control and independence. This evidence falls into the following three categories:
(1) Behavioral control covers whether the business has the right to direct or control how the work is done through instructions, training, or other means. Employees are generally given instructions on when and where to work, what tools to use, where to purchase supplies, what order to follow, and so on.
(2) Financial control covers whether the business has the right to control the financial and business aspects of the worker's job. This includes the extent to which the worker has unreimbursed business expenses; the extent of their investment in the facilities being used; the extent to which their services are made available to the relevant market; how they are paid; and the extent to which they can realize a profit or incur a loss.
(3) Type of relationship includes any written contracts that describe the relationship the parties intended to create; the extent to which the worker is available to perform services for other, similar businesses; whether the company provides the worker with employee-type benefits, such as insurance, a retirement plan, vacation pay, or sick pay; the permanency of the relationship; and the extent to which the worker's services are a vital aspect of the company's regular business.
If the business has the right to control or direct what will be done and how it will be done, then the workers are most likely employees. On the other hand, if the company can direct or control only the result of the work done and not the means and methods of accomplishing the result, then the workers are probably independent contractors.
One situation in which there is no uncertainty as to classification relates to a partner in a partnership. The IRS has long held that a bona fide member of an association is not an employee of the partnership, and a partner who devotes time and energy to conducting the partnership's trade or business or who provides services to the partnership as an independent contractor, is considered self-employed and is not an employee.
The obvious advantages for a business to treat an individual as an independent contractor are to avoid paying minimum wages, overtime, payroll taxes, worker's compensation insurance, unemployment tax, Social Security and Medicare contributions, health benefits, paid leave, 401(k) contributions, and unpaid leave under the Federal Family and Medical Leave Act.
Workers also have some tax-related benefits to be considered independent contractors, such as the ability to deduct certain business expenses that are not available to employees, the eligibility to set up their retirement plans, and the fact that they are not subject to withholding. Of course, many workers want to be considered employees for benefits such as vacation pay, overtime pay, and health insurance coverage.
Form SS-8 (Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be used when a worker's status is in doubt. An employer or a worker may complete this form; it asks the IRS to determine whether the worker is an employee or an independent contractor for federal tax purposes. Form SS-8 is filed separately from the requestor's tax return. The IRS does not issue determinations for proposed employment arrangements or hypothetical situations, and it will only issue a decision if the statute of limitations for the year at issue has yet to expire.
Independent contractors must pay self-employment (SE) tax on their net earnings. The SE tax is the individual's Social Security and Medicare tax contributions. For an employee, the employer pays half of these taxes, and the employee pays the other half through their payroll withholding, while a self-employed individual pays 100% of these taxes with their 1040 return using Schedule SE. A self-employed individual will not have income tax withheld from the income they receive as an independent contractor and will usually need to make estimated tax payments during the year to cover their income and SE tax liabilities.
If an individual has filed Form SS-8 and the IRS has determined he is an employee, or if an individual believes they were misclassified as an independent contractor and wants to avoid paying self-employment tax on 1099-NEC or 1099-MISC income – or when they have filed an SS-8 but has not received a response – that individual can file Form 8919, which only requires payment of what would have been withheld if the worker had been treated as an employee. Form 8919 requires the employee to choose one of these codes:
Code A. I filed Form SS-8 and received a determination letter stating that I am an employee of this firm.
Code C. I received other correspondence from the IRS that states I am an employee.
Code G. I filed Form SS-8 with the IRS but am still awaiting a reply.
Code H. I received a Form W-2 and a 1099-NEC or 1099-MISC from this firm for the same tax year. The amount on Form 1099-NEC or 1099-MISC should have been included as wages on Form W-2.
If using Code H, an SS-8 should not be filed. Here are some examples of amounts that are sometimes erroneously included (but not necessarily deliberately misclassified) on Form 1099-NEC or 1099-MISC and that should have been reported as wages on Form W-2: employee bonuses, awards, travel expense reimbursements not paid under an accountable plan, scholarships, and signing bonuses.
If Code G on Form 8819 is used, the worker and the firm that paid the worker may be contacted for additional information. Using this code does not guarantee that the IRS will agree with the worker's opinion on their status. Suppose the IRS disagrees that the worker is an employee. In that case, the worker may be billed an additional amount for the employment tax, as well as penalties and interest resulting from the change in the worker's status.
If the IRS determination is for multiple open years, the employee can amend returns for available years to recover a portion of the self-employment tax paid.
A business that misclassifies an employee can be liable for employment taxes for that worker and owe various penalties. If the employer willfully misclassifies the employee, additional fines and possibly prison time apply. More penalties could be piled on by the state where the business operates, and the misclassified employee could be entitled to back wages for overtime, mandated work breaks, retirement benefits, and more. Misclassifying a worker can be very costly to the employer.
The IRS offers an optional Voluntary Classification Settlement Program allowing businesses to reclassify their employees for future employment tax purposes. It also provides partial relief from federal employment taxes for eligible companies who agree to treat their workers as employees prospectively. Businesses must meet specific eligibility requirements and apply by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP), and enter into a closing agreement with the IRS.
If you have questions about your worker status as an employee or independent contractor, please get in touch with this office for assistance.