Employment Tax Bulletin (July 2010)
Increased IRS Scrutiny of
E. Stein, a partner, and
E. Houston, an associate, in the Los Angeles
office of Pillsbury Winthrop Shaw Pittman
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In September 2009, the Internal Revenue Service announced its intention to conduct an employment tax National Research Program beginning in 2010. This program will result in employment tax audits of approximately 6,000 U.S. companies over the next three years, and among other things, will focus on worker classifications. To be ready for such audits, employers should review worker classifications immediately.
The IRS National Research Program has already begun and, if a company is audited, the IRS examiner must review worker classifications even if all of the applicable workers are currently classified as employees. Due to this increased scrutiny, it is very important for companies to correctly determine whether their workers are properly classified as employees or independent contractors.
In addition to IRS scrutiny, federal legislation has also been proposed by Representative Lynn Woolsey and Senator Sherrod Brown in the "Employee Misclassification Prevention Act" (H.R. 5107, S. 3254). If adopted, this bill would amend the Fair Labor Standards Act to require companies to keep records of non-employees who work as independent contractors and to notify both employees and non-employees of their classification, and would impose special penalties for misclassifying those workers. This bill would also require states to conduct audits to identify employers who misclassify workers for unemployment compensation purposes and to strengthen their own fines for misclassification.
Hiring independent contractors rather than employees can be beneficial, as companies that do so avoid withholding income tax and contributing to state unemployment tax, Social Security, and federal unemployment tax. In addition, company-sponsored benefit plans and wage and hour laws do not apply. However, if a company misclassifies an employee as an independent contractor, the penalties can be severe. A company may be liable for employment taxes, interest, penalties, and retroactive benefits. Penalties may also be imposed for failure to file required tax forms.
IRS Factors for Classifying Workers
In determining whether a worker is an employee or an independent contractor for federal tax purposes, the general IRS rule is that an individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result. On the other hand, anyone who performs services is an employee if the employer controls what will be done and how it will be done. Essentially, if an employer controls the details of how a worker performs the services, then the worker is likely an employee.
To review the degree of control that is present, the IRS considers the following: (1) behavioral control, (2) financial control and (3) the type of relationship.
To determine a worker's independent contractor/employee status, all of the factors must be evaluated, but there is no specific number of factors that makes a worker an employee or an independent contractor.
- "Behavioral control" refers to factors that show whether there is a right to direct or control how the worker does the work. The behavioral control factors generally include the type and degree of instructions given, the amount of training that is provided, and whether an evaluation system is in place that measures the details of how the work is performed rather than just the end result.
- "Financial control" refers to factors that show whether or not the company has the right to control the economic aspects of the worker's job. The financial control factors generally include whether the worker has made a significant investment in the equipment used, has an opportunity for profit or loss, makes his or her services available to the market, and whether the worker is paid a regular wage for an hourly, weekly, or other period of time or a flat fee for the job.
- "Type of Relationship" refers to factors that show how the worker and the company perceive their relationship. The relevant factors include, among other things, whether a written contract is in place, whether benefits are provided, and whether the worker has been retained with the expectation that the relationship will continue indefinitely.
Exceptions to General IRS Rule
There are specific statutory exceptions to the IRS analysis described above. For example, certain workers (such as corporate officers and certain salespersons) must be classified as employees for Social Security tax purposes. In the event of an IRS audit, Section 530 of the Revenue Act of 1978 may provide some protection against retroactive reclassification of independent contractors as employees, even when the worker has otherwise met the requirements for employee status. Determination of employee status under other federal laws, such as the Fair Labor Standards Act, may also differ in some respects from the general IRS rule.
In addition, there are various state tests for independent contractor/employee classification. For example, in California, courts apply the "economic realities" test adopted by the California Supreme Court to determine worker status under several labor statutes. S. G. Borello & Sons, Inc. v Dept. of Industrial Relations (1989) 48 Cal.3d 341. In general, the economic realities test focuses on factors that suggest whether a worker is indeed in business for him or herself. Some of the relevant factors include whether the work consists of furnishing a personal service, whether the worker has made a substantial investment in equipment or employees, whether the worker works for more than one company at a time, whether there is an exclusive contract, and whether the worker generally holds him or herself out to be running his or her own business. Further, in California, various state agencies are involved in determining independent contractor status, depending upon which laws are involved. For example, the California Division of Labor Standards Enforcement is concerned with whether the wage, hour, and workers' compensation insurance laws apply while the California Employment Development Department is concerned with employment-related taxes. Since different laws may be implicated in a particular situation, it is possible that the same individual may be considered an employee for purposes of one law and an independent contractor under another law.
Time to Review Worker Classifications Is Now
Due to the increased scrutiny by the IRS, possible new federal legislation, and potentially severe consequences of misclassification, it is very important that companies review all worker classifications now to reduce their potential exposure in an IRS
This material is not intended to constitute a complete analysis of all
tax considerations. Internal Revenue Service regulations generally
provide that, for the purpose of avoiding United States federal tax
penalties, a taxpayer may rely only on formal written opinions meeting
specific regulatory requirements. This material does not meet those
requirements. Accordingly, this material was not intended or written to
be used, and a taxpayer cannot use it, for the purpose of avoiding
United States federal or other tax penalties or of promoting, marketing
or recommending to another party any tax-related matters.
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