Employee vs. Independent Contractor: The Importance of Proper Classification Dominic L. Daher, MAcc, JD, LLM in Taxation Director of Internal Audit and Tax Compliance Adjunct Professor of Law University of San Francisco Dawn G. Mayer, JD, LLM in Taxation Tax Manager, University of San Francisco Adjunct Professor of Accountancy 2012 NACUBO TAX FORUM October 17, 2012
Overview Background Current IRS Classification Factors Evaluating Classification Factors Reporting and Withholding Consequences for Misclassifying Workers Obtaining Section 530 Relief Review of Different Worker Arrangements Contract Drafting Considerations Additional Resources 2
Background Worker classification continues to be a major focus in IRS audits IRS Employment Tax National Research Project audits of 6,000 employers IRS Voluntary Worker Classification Settlement Program eligible employers pay 10% of employment taxes due 3
IRS Classification Factors IRS 20 Factor Test published in 1987 (Rev. Rul. 87-41) IRS Training Materials -- updated categories and factors published in 1996: Behavior Control Financial Control Relationship of the Parties Current IRS website reflects Training Materials 4
Current IRS Classification Factors Behavioral Control: Does the university have the right to control how the job is done? Type of instruction given Degree of instruction Evaluation system Training 5
Current IRS Classification Factors-- Continued Financial Control: Does the university have the right to control the economic aspects of the worker s job? Significant investment Unreimbursed expenses Opportunity for profit or loss Services available to market Method of payment 6
Current IRS Classification Factors-- Continued Relationship of the parties: How do the university and the worker perceive their relationship to each other? Written contract Employee benefits Permanency of the relationship Regular activity of the business, i.e., university 7
Evaluating Classification Factors Per the IRS website, businesses must weigh all of the factors: There is no magic number that makes a worker an employee or contractor No one factor is determinative Factors relevant in one situation may not be relevant in another 8
Evaluating Classification Factors-- Continued Many schools use a checklist to evaluate the factors A properly completed checklist provides strong evidence on audit that the university reviewed the factors See University of San Francisco checklist 9
Reporting and Withholding on Payments to Contractors Federal: U.S. payee -- Form 1099-MISC, no withholding if TIN obtained NRA payee -- Form 1042-S, 30% withholding unless treaty applies State: May be withholding and reporting obligations Example: California requires 7% withholding on payments to nonresident contractors 10
Federal Tax Consequences for Misclassifying Workers IRC Section 3509 Reduced Rates -- Available if Forms 1099 timely filed for workers: Employer share of FICA 7.65% 20% of EE's share of FICA 1.53 Income tax withholding 1.50 Total IRC 3509 Percentage 10.68% 11
Other Potential Consequences State income tax withholding Disability insurances Unemployment insurance Workers compensation Benefits, including heath and retirement Minimum wage and overtime Interest and penalties 12
Section 530 Relief Enacted as Section 530 of the Revenue Act of 1978 not part of the IRC Provides businesses with relief from federal employment taxes FICA, FUTA, and income tax withholding Does not terminate the worker s employment tax liability 13
Section 530 Relief--Continued Three requirements must be met to obtain Section 530 relief: Reasonable basis Substantive consistency Reporting consistency 14
Reasonable Basis The business must have a reasonable basis for treating workers as independent contractors: Judicial precedent, PLR, TAM, etc. Past IRS audit of workers or similar positions Longstanding practice by a significant segment (25%) of the industry Other reasonable basis, e.g., independent legal advice 15
Consistency Requirements Both the substantive and reporting consistency requirements must be met for Section 530 relief: Consistent treatment of workers in question and similarly situated workers as contractors Consistent filing of Forms 1099 for all workers treated as contractors 16
Example 1: Adjunct Faculty A full-time engineer worked as an adjunct faculty member for two universities: He was paid on a course-by-course basis over several years He taught on campus but otherwise worked from home communicating with students on e-mail He maintained a website devoted to his teaching activities The universities treated him as an employee but he challenged his status in Tax Court. 17
Example 1: Answer The Tax Court concluded the faculty member was an employee of both universities: Services as an adjunct professor were part of the regular business of the universities He bore no risk of loss from under enrollment He had worked for both universities continuously for several years His contracts treated him as an employee Beitel v. Commissioner, T.C. Summary Opinion, (2001) 18
Example 2: Computer Consultant A university hired a computer consultant to set up programs for statistical analysis: The work was performed at the consultant s business location He provided his own equipment and supplies The worker received no training on how to do the work He advertised his services and had other clients 19
Example 2: Answer The IRS ruled the worker was an independent contractor: The worker was responsible only for providing a finished product by a specified time He used his own facilities, equipment, and supplies Because of these expenses, he assumed the risk for a profit or loss He performed services for others 20 PLR 9320020
Example 3: Physician A university hired a physician to provide medical care to students: The physician had her own private practice She worked on-call for the university clinic The physician received an hourly wage but no benefits There was no written contract between the physician and the university, which treated her as an employee 21
Example 3: Answer The IRS ruled the physician was an employee: The physician s services were integral to the clinic s functions The services were performed on the university s premises and subject to clinic protocols There was a continuing relationship even though the physician worked on-call The university had treated the physician as an employee PLR 9326015 22
Example 4: Hair Stylist A university hired a hair stylist to work in the campus barber shop: Per the contract, the worker incurred the costs of her license, equipment, and insurance The university set prices and the hours of operation The worker was required to wear a uniform She worked full-time for 6 months and received no benefits 23
Example 4: Answer The IRS ruled that the stylist was an employee: The worker was required to work set hours She worked 6 months, which indicated a continuing relationship Her services were integral to the function of the campus barber shop She lacked investment in facilities, indicating a dependence on the university PLR 9405015 24
Example 5: Law Student A firm hired a law student to provide part-time legal research and litigation support: The student set his own hours and decided where to work the firm, school, at home He was paid by the hour and received no benefits except for parking reimbursements The firm reviewed his work and signed all court filings he drafted The student did not have a contract with the firm 25
Example 5: Answer The IRS ruled that the student was an employee: His services were integral to the firm The student had no capital investment in an independent business or risk of loss The firm supplied the student with a computer and other office resources The firm had the right to direct and control the work There was no contract establishing the student s status The firm reimbursed the student s parking expenses TAM 9639001 26
Contract Drafting Considerations The following points should be considered in drafting an independent contractor agreement: Avoid employee language throughout the agreement Clarify that the worker requires no training Permit the contractor to use assistants in completing the work Limit the duration of the contract to a year or less The scope of work should be for a specific, finite project The end product should be stressed progress reports should not be required 27
Drafting Considerations--Continued Clarify that the contractor will not work exclusively for the university Permit the contractor to determine the place of work Payment should be made for work completed, not by the hour, week, month, etc. Clarify that expenses will not be reimbursed, including travel, equipment, supplies, etc. Termination of the agreement should require payment for work completed Avoid additional termination payments that reduce the risk of losses 28
Additional Resources Independent Contractor of Employee? IRS Training Materials http://www.irs.gov/pub/irs-utl/emporind.pdf IRS Website: Independent Contractor (Self-Employed) or Employee http://www.irs.gov/businesses/small/article/ 0,,id=99921,00.html 29
Questions 30