New guidance issued by the U.S. Department of Labor provides clarification on the definition of an independent contractor (Administrator’s Interpretation No. 2015-01). This guidance may be helpful to employers who are contemplating hiring extra workers but are concerned about all of the obligations associated with hiring employees, including health insurance, workers’ compensation, unemployment insurance, sick time and vacation time.
Factors to Decide Worker Classification
The federal government and courts apply an “economic realities test” when deciding whether workers should be classified as independent contractors or employees for federal employment tax purposes and compliance with labor laws:
1. Degree of control,
2. Investment in equipment and facilities,
3. Whether the worker has an opportunity for open-ended profit or outright loss,
4. Whether the worker can be discharged,
5. Whether work is related to the employer’s core business,
6. Permanency of relationship between the employer and worker, and
7. Relationship the employer and worker believed they were creating.
The recently issued Department of Labor guidance also introduces the concept of “economic dependence” into the economic realities test.
In addition, there’s historical precedent for classifying these types of workers as independent contractors:
Contact your tax and legal advisers for help deciding whether to classify workers as employees or contractors. This is an important decision that can have significant consequences if handled improperly.
Employers generally prefer to classify workers as independent contractors to lower costs, even if it means less control over a worker’s day-to-day activities. But the government is on the lookout for businesses that classify workers as independent contractors to reduce taxes or avoid their health insurance obligations under the Affordable Care Act (ACA).
Here’s an overview of the worker classification issue, along with the scoop about a form that can be filed by your business or a worker to ask the IRS to make worker classification determinations.
Why Classification Matters
When your business classifies a worker as an employee, you generally must withhold federal income tax and the employee’s share of Social Security and Medicare taxes from his or her wages. Your business must then pay the employer’s share of Social Security and Medicare taxes, pay federal unemployment tax, file federal payroll tax returns and follow lots of other burdensome IRS and DOL rules.
You may also get socked with state and local unemployment and worker compensation taxes and have to comply with more rules and regulations. Dealing with all this can cost thousands of dollars per year for each employee.
On the other hand, independent contractor status is attractive because you don’t have to worry about employment tax issues, and you don’t have to provide expensive fringe benefits like health insurance, retirement plans and paid vacations. If you pay $600 or more to an independent contractor during the year, you must issue a Form 1099-MISC to report what you paid. That’s generally the extent of your bureaucratic responsibilities.
Businesses now have an extra incentive to classify new hires as independent contractors: It lowers their headcounts for purposes of complying with the ACA, thereby reducing their health insurance costs and reporting requirements.
Here’s the rub: If you incorrectly treat a worker who is actually an employee as an independent contractor, your company could be assessed unpaid payroll taxes plus interest and penalties. You also could be liable for employee benefits that should have been provided but weren’t, including significant penalties under federal laws.
How to Support Contractor Status
The DOL and IRS apply an “economic realities test” to determine worker classification (see “Factors to Decide Worker Classification” at right). But the determination traditionally boils down to this: A worker is an independent contractor if you have little or no control over the way that person gets the job done. If you provide substantial day-to-day supervision, the worker is probably an employee.
To complicate matters, a worker may also be considered an employee if he or she works full-time for you, has no other significant clients, is required to make extensive daily progress reports and gets paid by the hour (or day, week or month) rather than by the job.
It certainly helps your independent contractor argument if the work is performed away from your premises using equipment owned by the worker. But those facts aren’t a cure-all — especially if you treat another worker in essentially the same circumstances as an employee.
A written contract can help support a worker’s independent contractor status and minimize ambiguity. The contract should:
- Refer to the worker as a contractor and refer to payments as contract payments (not wages),
- Permit the worker to take on other projects,
- Refrain from requiring full-time work or request daily visits to your premises,
- Specify that payment is due on completion of the project or at designated progress points,
- Limit the term, rather than be open-ended, and
- State you won’t pay for expenses except in specific instances.
Of course, you must then adhere to the terms of the contract.
Why Businesses Refrain from Using an IRS Form
Alternatively, you can file IRS Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Then, the IRS will prescribe how to classify a worker. However, be aware that the IRS has a history of reflexively classifying workers as employees rather than independent contractors.
Businesses should consult with their tax advisers before choosing this alternative, because Form SS-8 may alert the IRS that your business has worker classification issues — and inadvertently trigger an employment tax audit.
When Workers File Form SS-8
A worker seeking a determination of his or her status as an employee or independent contractor can also file Form SS-8. Disgruntled former workers are especially likely to file the form to show that a business improperly denied employee benefits by classifying him or her as an independent contractor.
Once a worker files Form SS-8, the IRS will send a letter to the business that explains the situation, provides the worker’s identity and includes a blank Form SS-8. The IRS will ask the business to complete the form and return it to an assigned IRS technician who will render a worker classification decision. The business and the worker will both receive a written determination letter that states the IRS’s conclusion.
If you receive notice that one of your workers has filed Form SS-8, understand the following:
- The odds are good that the worker’s Form SS-8 will skew the facts in favor of employee status, because the worker understands that status is more beneficial to him or her. Workers may claim employee status to gain health, retirement and paid-to-off benefits and to eliminate self-employment tax liabilities.
- The IRS technician may discount the Form SS-8 responses that you turn in and decide the worker is an employee.
- Form SS-8 instructions state that the IRS’s determination letter applies only to the worker (or class of workers) that requested a determination.
- Your business can safely disregard the IRS’s determination letter if you’re entitled to Section 530 relief. Basically, this relief is available if there’s a historical or tax law precedent for treating the type of worker in question as an independent contractor if 1) your business has always treated such workers as independent contractors and 2) has reported payments to them on Form 1099-MISC. When Section 530 relief is available, the IRS cannot force you to reclassify affected workers as employees. Your tax adviser can help you determine if your business qualifies for Section 530 relief.
- Neither the Form SS-8 determination process nor the review of any records in connection with the determination constitutes an official IRS audit. While there’s no procedure to appeal a Form SS-8 determination, ask your tax adviser if your business can simply disregard it.
Stand Your Ground
What should you do if your business has been properly classifying workers as independent contractors and a worker turns in a Form SS-8 indicating the contrary? You may want to continue to treat the worker as a contractor — regardless of what the IRS determination letter says. However, if you stand your ground, be prepared for an employment tax audit. Your tax and legal advisers can help with that and other issues involved with independent contractors.