The status of a worker as an “employee” or an “independent contractor” continues to be an issue for employers and the IRS. The basis of the issue is how the particular designation affects employers’ payment of employment taxes.
For those employers who have incorrectly in the past treated workers who are employees as independent contractors, the IRS has instituted a program to provide relief to an employer agreeing to prospectively treat such workers as employees.
Generally, an employee relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the service, not only as to results but also as to how they are to be accomplished.
There are three broad tests in determining who is an employee.
The first is “Behavioral Control,” which means an employee is generally subject to instructions about when, where and how to work. All of the following are examples: when and where to do the work; what tools or equipment to use; what workers to hire or to assist with work; where to purchase supplies and services; what work must be performed by a specified individual; and what order or sequence to follow.
Second is “Financial Control.” Facts that show whether the business has a right to control the business and financial aspects of the worker’s job include: the extent to which the worker has unreimbursed business expenses; the extent of the worker’s investment; the extent to which the worker makes services available to the relevant market; how the business pays the worker; and the extent to which the worker can realize a profit or loss.
Third is “Type of Relationship.” Facts that can confirm whether the relationship is an employment relationship or an independent contractor relationship include written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship. However, in close cases, the written contract can make a difference.
Another issue here is whether the business provides the worker with employee-type benefits, such as insurance, pension plan, vacation or sick pay. Also, the permanency of the relationship: If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence of intent to create an employer-employee relationship. The final factor is the extent to which services performed are a key aspect of the company’s regular business.
If it is determined that the worker is an employee, the employer is required to deduct and pay Social Security taxes and withhold taxes. If the employer fails to deduct and withhold any tax due to treating the employee as an independent contractor rather than an employee, the employer is liable for:
Tax withholding — The amount of the employer’s liability for federal income tax withholding shall be equal to 1.5 percent of the wages paid to such employee.
Social Security taxes — In addition, the employer is liable for its share of Social Security taxes (FICA) and an additional penalty of 20 percent of the FICA that should have been withheld.
Increased penalties — If Forms 1099 were disregarded, penalties increase to 40 percent for FICA and 3 percent on wages.
The IRS implemented a Voluntary Worker Classification Settlement Program (VCSP) in 2011, allowing employers to voluntarily reclassify workers as employees without going through the examination process and normal administration correction procedures. VCSP allows an employer to pay 10 percent of the employment tax liability that may have been due on compensation paid workers for the most recent tax year, removes penalties and interest on liability, and provides amnesty to the employer from an employment tax audit on prior years for reclassified workers.
The VCSP offers employers a reasonable way to change the classification of their independent contractors to employees. The voluntary penalties could be far less than the results of an audit that reclassifies workers for all open years and requires the payment of back taxes and penalties.
John M. Stinar is an attorney with Stinar & Zendejas LLC, a full-service business and estate planning firm. Find information at coloradolawgroup.com or call 635-4200.