Is Your Worker an Employee or Independent Contractor for Payroll Tax Purposes?
The classification of workers as employees or independent contractors determines whether an employer is responsible for withholding and paying payroll taxes. The worker's classification is based chiefly on whether you have the right to direct or control the worker's work. The IRS has a 20-factor analysis you can use to assist you in making a determination. There is also a safe haven rule, as well as the opportunity to request a ruling from the IRS as to employee or independent contractor status.
The obligation to withhold and to pay payroll taxes applies to employers with workers who are properly classified as employees as opposed to independent contractors. The key word is "properly" classified.
The benefit of having workers classified as independent contractors is that generally, businesses are not responsible for payroll tax obligations. On the other hand, only in rare circumstances will a business be relieved from payroll tax obligations with respect to employees. Proper classification requires that a business follow detailed criteria to distinguish between employees and independent contractors.
The IRS and the various state tax agencies rely on common law rules to distinguish employees from independent contractors. Under these rules, your workers are employees if you have the right to direct and control them in the way they work, both as to the final results and as to the details of when, where, and how their work is done.
Even if you grant your workers considerable discretion in determining how they do their work, as long as you retain the legal right to control their activities, the workers are common-law employees.
There are innumerable ways in which you can exercise control over a worker. There is no clear definition of just how much control on your part is enough to cause a worker to be classified as an employee rather than an independent contractor. Each case depends on an analysis of its own particular set of facts.
To assist you with this analysis:
- The IRS has published the 20 factors that its auditors use as guidelines in resolving the employee-or-contractor issue.
- There is a "safe haven" rule that generally allows you to treat a worker as not being an employee for employment tax purposes, regardless of the worker's actual status under the common-law test, under certain specified circumstances.
- You can obtain an IRS determination of the worker's status, if you're still uncertain about a worker's proper classification.
Misclassification of workers is a red flag for the IRS and the courts. Employers often hold the common misconception that they can avoid incurring payroll tax obligations simply by having their workers sign agreements that declare the workers to be independent contractors. Such self-serving agreements carry little, if any, significance under the common-law rules.
If your actions show an employer-employee relationship, then your workers are employees regardless of how you choose to describe them.
The IRS's 20-Factor Analysis
When IRS auditors analyze whether a worker is an employee or independent contractor, they generally work through a list of 20 different factors before concluding whether a sufficient level of control is present to create an employer-employee relationship. They also look at any other information that helps determine the degree of control and the degree of independence. The IRS generally groups evidence regarding a right to control into three primary categories:
- behavioral control—regarding how a worker performs the work (e.g., instructions, training);
- financial control—regarding the business aspects of the worker’s activities (e.g., unreimbursed expenses, profit or loss opportunity, payment method, significant investment, services available to the relevant market);
- relationship of the parties—regarding how the business and worker perceive their relationship (e.g., employee benefits, written contracts/intent of parties, discharge/termination, regular business activity).
You should go through this same exercise, particularly if you're trying to claim that someone who does work for you is an independent contractor and not your employee.
Keep in mind that the importance of each fact will vary depending on the type of work being done and the circumstances of your own particular case. Because this is a rather subjective analysis, your goal should be to honestly assess how great a risk you'll be taking if you plan to treat a worker as an independent contractor. In close cases, talk to your tax professional or request an IRS determination of the worker's status.
- Instructions. Workers who must comply with your instructions as to when, where, and how they work are more likely to be employees than independent contractors.
- Training. The more training your workers receive from you, the more likely it is that they're employees. The underlying concept here is that independent contractors are supposed to know how to do their work and, thus, shouldn't require training from the purchasers of their services.
- Integration. The more important that your workers' services are to your business's success or continuation, the more likely it is that they're employees.
- Services rendered personally. Workers who must personally perform the services for which you're paying are more likely employees. In contrast, independent contractors usually have the right to substitute other people's services for their own in fulfilling their contracts.
- Hiring assistants. Workers who are not in charge of hiring, supervising, and paying their own assistants are more likely employees.
- Continuing relationship. Workers who perform work for you for significant periods of time or at recurring intervals are more likely employees.
- Set hours of work. Workers for whom you establish set hours of work are more likely employees. In contrast, independent contractors generally can set their own work hours.
- Full time required. Workers whom you require to work or be available full time are likely to be employees. In contrast, independent contractors generally can work whenever and for whomever they choose.
- Work done on premises. Workers who work at your premises or at a place you designate are more likely employees. In contrast, independent contractors usually have their own place of business where they can do their work for you.
- Order or sequence set. Workers for whom you set the order or sequence in which they perform their services are more likely employees.
- Reports. Workers whom you require to submit regular reports are more likely employees.
- Payment method. Workers whom you pay by the hour, week, or month are more likely employees. In contrast, independent contractors are usually paid by the job.
- Expenses. Workers whose business and travel expenses you pay are more likely employees. In contrast, independent contractors are usually expected to cover their own overhead expenses.
- Tools and materials. Workers who use tools, materials, and other equipment that you furnish are more likely employees.
- Investment. The greater your workers' investment in the facilities and equipment they use in performing their services, the more likely it is that they're independent contractors.
- Profit or loss. The greater the risk that your workers can either make a profit or suffer a loss in rendering their services, the more likely it is that they're independent contractors.
- Works for more than one person at a time.The more businesses for which your workers perform services at the same time, the more likely it is that they're independent contractors.
- Services available to general public. Workers who hold their services out to the general public (for example, through business cards, advertisements, and other promotional items) are more likely independent contractors.
- Right to fire. Workers whom you can fire at any time are more likely employees. In contrast, your right to terminate an independent contractor is generally limited by specific contractual terms.
- Right to quit. Workers who can quit at any time without incurring any liability to you are more likely employees. In contrast, independent contractors generally can't walk away in the middle of a project without running the risk of being held financially accountable for their failure to complete the project.
Safe Haven for Proper Classification of Workers
The tax law provides a safe haven rule that, for some employers, can minimize uncertainty when it comes to the proper treatment of workers as employees or independent contractors for purposes of employment taxes. If you meet the terms of the rule, your characterization of an individual as an independent contractor will not be challenged.
This rule provides that an individual who has consistently not been treated as a common-law employee for any period after 1977 will not be reclassified as an employee if you, the employer, have filed all required federal tax returns, including information returns (Forms 1099-MISC), and if you had a reasonable basis for not treating the individual as an employee.
In other words, if you have always treated a certain worker as an independent contractor and properly filed the corresponding tax returns, you may be in the clear.
What's a "reasonable basis" for not treating someone as an employee? There are three factors you may use:
- judicial precedent, published rulings, or technical advice or a letter ruling you received from the IRS
- a past audit by the IRS in which there was no assessment for your treatment, for employment purposes, of workers holding positions substantially similar to the position held by the worker in question
- long-standing recognized practice of a significant segment of the industry in which the individual works (for example, most workers in your industry are treated as independent contractors by employers)
Legislation in this area has clarified and added to the requirements for qualifying for the safe haven:
- Employers can't rely on a clean bill of health from an audit unless it specifically examined the issue of whether the worker involved or any worker holding a substantially similar position should be treated as an employee. (Employers can still rely on prior audits that began before 1997, even if they weren't related to employment tax matters.)
- To prove that a "significant segment" of your industry treats such workers as independent contractors doesn't require you to show that more than 25 percent of your industry treats them as independent. (If less than 10 percent of your industry treats such workers as independent contractors, it's unlikely to be considered a significant segment.)
- An industry practice need not have continued for more than 10 years, or to have begun prior to 1979, for it to be considered long standing based on the particular facts and circumstances. This allows new industries to take advantage of the safe haven rule relief.
- For audits beginning after 1996, IRS employees must, at the beginning of an audit involving worker classification issues, provide you with written notice of the safe haven provisions. (If the worker classification issue arises after the audit begins, you're entitled to notice at the point the issue is first raised.)
- Once you establish that it was reasonable not to treat a worker as an employee under the safe haven rule, the burden of proof shifts to the IRS as to the treatment of that worker, for purposes of the safe haven rule.
If you don't satisfy any of the provisions above, you're not out of the ball game yet. Employers have been found to have a reasonable basis for treating workers as independent contractors when their treatment is based on something similar to the specific provisions spelled out.
A corporation obtaining services from dentists relied on a statement from the state dental board's council that it would be illegal to enter into an employer-employee relationship with the dentists. In this case, the IRS granted the corporation safe haven relief based on this reliance.
On the other hand, an employer who treats certain workers as employees and others as independent contractors when the two groups hold substantially similar positions will more than likely be denied relief under the safe haven rule.
Also, if you have treated someone as an employee anytime after 1977 and try to convert him or her to an independent contractor, you are not eligible for the safe haven.
Finally, what happens if your workers don't satisfy the requirements of the safe haven rule? Your workers aren't automatically employees — the common law test of the workers' status is applied.
Requesting a Worker Classification Ruling From the IRS
Unfortunately, the standards used in distinguishing between employees, for whom you have payroll tax obligations, and independent contractors, for whom you do not, are highly subjective. So it wouldn't be at all unusual for a tax auditor to look at the same facts that you did and to reach an entirely different conclusion.
So how do you limit your risk of receiving a bill for unpaid payroll taxes because you misclassified a worker? We suggest that you always talk to your tax professional before you take the position that any of your workers are independent contractors.
In close cases, you'd be well advised to take the added step of requesting an IRS determination as to a worker's proper classification. If the IRS is going to disagree with your classification, you can save a lot in tax penalties, interest, and legal costs if you find that out now rather than several years down the road.
How do you obtain an IRS determination? You request one by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. You supplement the form with various information about your relationship with the worker (or class of workers) for whom you're requesting the ruling.
For example, your request usually must include a copy of any agreement you may have with the worker, a detailed account of the services provided, and a description of how you supervise or direct the worker's services and pay for the services.
Never submit an advance ruling request without first having it reviewed by your tax professional. Why? Because of the subjective nature of these classifications you want to be sure that each favorable factor is highlighted. At the same time, you need to be sure that no material facts are omitted or presented in a misleading fashion. An experienced professional can help ensure that each statement in the request reflects your case in its best light. Again, this is particularly important because you're asking the IRS to make a very subjective decision.
Salespersons and Independent Contractors Subject to Payroll Taxes
The general rule is that you only have payroll tax obligations with respect to workers who are considered employees, and you don't have to withhold or pay payroll taxes for independent contractors. However, when it comes to the tax laws, there's an exception for virtually every rule!
In this case, the exception is that for workers in certain occupations, you will be required to withhold and pay certain payroll taxes under certain circumstances even if those workers are not your common-law employees. These so-called "statutory employees" are:
- Agent-drivers and commission drivers who deliver specified products — they distribute beverages (other than milk) or meat, vegetables, fruit, or bakery products or if they pick up and deliver laundry or dry cleaning—and:
- operate their own trucks or the trucks of the persons for whom they perform services;
- serve customers designated by their principals and customers they solicit on their own initiative;
- make wholesale or retail sales; and
- are paid commissions on their sales or earn the difference between what they charge their customers and what they pay their principals for the products or services they sell.
- Traveling or city salespersons (other than agent-drivers or commission drivers) who work full time on your behalf and remit orders from customers who are retailers, wholesalers, contractors, or operators of hotels, restaurants, or other businesses whose primary function is the furnishing of food or lodging. The orders must be for items that your customers will resell or will use as supplies in their business operations.
- Homeworkers who perform work from you, generally on a contract or piecework basis, in their own homes or in the homes of others. For example, persons you hire to do word processing work on their home computers would be homeworkers.
- Full-time life insurance salespersons who work primarily for one insurance company.
When you retain the services of any of these types of workers who would otherwise be independent contractors, you are not required to withhold income taxes from their compensation. However, you must withhold and pay FICA taxes and, in the case of drivers and traveling salespersons, you must pay federal and state unemployment taxes, if each of the following conditions exists:
- the service contract, whether written or oral, contemplates that the worker will personally perform substantially all of the work,
- the worker's investment in equipment and property, other than transportation equipment, used in providing services is insubstantial,
- the worker performs services for you on a continuing (that is, regular or frequently recurring) basis, and
- with respect to homeworkers, you've paid the workers $100 in cash wages during the year. Once you've reached the $100 threshold, all wages paid during the year are subject to the FICA taxes, including the initial $100 as well as any noncash wages that you pay.
To avoid confusion, it's crucial to clarify when the "statutory employee" designation becomes relevant. The designation is relevant only if a worker is not a common-law employee. And if a statutory employee is a common-law employee? In that case, all the normal payroll tax obligations apply.
Salespersons Treated as Contractors
For the most part, salespersons are treated the same as any other workers for payroll tax purposes. Thus, you'll generally have to withhold and pay payroll taxes if your salespersons are your employees. And, except with respect to certain traveling or city salespersons, you won't have any payroll tax obligations with respect to salespersons who are independent contractors.
However, there are two types of salespersons for whom you may be relieved of all federal and most state payroll taxes even if they are properly classified as being your employees:
- real estate agents
- direct sellers
This relief is available only if:
- substantially all the compensation you pay these salespersons is directly related to sales or other output, as opposed to the number of hours they work, and
- the salespersons perform their services pursuant to written contracts specifying that they will not be treated as employees for payroll tax purposes.
"Direct sellers" are persons who sell or solicit the sale of consumer products at a place of business, such as a home, that is not a permanent retail establishment. The sales can be to the ultimate consumer or to a buyer who purchases the products for resale and on a buy-sell basis, deposit-commission basis, or similar basis.
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