The worker classification issue persists due to the inherent tug-of-war between workers, who tend to prefer employee status, and payers/businesses, which often prefer to classify their workers as independent contractors. The reasons are simple: Workers want payers to be held responsible for payroll taxes and employee benefits (pensions, insurance, etc.), and payers/businesses want to shift that responsibility to their workers to save money and lessen their administrative burdens. The proper classification of workers has for decades affected many businesses and workers as well as taxing authorities and other agencies such as the U.S. Department of Labor and similar state labor regulators.
In light of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, which is partly policed by the IRS, worker classification is even more top-of-mind for taxpayers and the CPAs who advise them. PPACA requires employers in many cases to provide employees with health insurance. Therefore, payers/businesses have even more incentive to classify workers as independent contractors to avoid PPACA costs and burdens.
The IRS knows that the U.S. Treasury loses billions of dollars annually due to worker misclassification and has made closing the tax gap (the difference between what is actually collected and what should be collected) a strategic priority by correcting as many misclassifications as possible. Workers who are classified as employees and receive a Form W-2, Wage and Tax Statement, are historically much more compliant with their tax obligations. This item provides high-level guidance on IRS worker classification matters, but labor issues that may apply are outside its scope.
The 20 Common Law Factors to Determine a Worker's Status
There is no bright-line test to determine a worker's status, but the IRS looks to the 20 common law factors in Rev. Rul. 87-41. Practitioners need to be aware of these factors to help their business clients properly classify workers. Worker instructions, training, hours, location, realization of profit or loss, and investment in facilities are among the factors to review. The factors boil down to who has control over employee behavior and financial resources and the relationship between the parties.
Section 530 Safe Harbor
Section 530 of the Revenue Act of 1978, P.L. 95-600, established safe-harbor rules that allow an employer in many cases to treat a worker as not an employee for employment tax purposes, regardless of the worker's actual status under the common law test. Section 530 often serves as the best defense for payers that have a reasonable basis to classify a worker as an independent contractor.
Section 530 states in part that an individual will not be considered an employee if the payer/business:
- Consistently treated the worker and other workers performing similar tasks as nonemployees for all periods;
- Had a reasonable basis for doing so; and
- Filed all required information returns, such as Form 1099-MISC, Miscellaneous Income.
Practice tip: Section 530 relief is officially considered (and possibly granted) by an IRS examiner at the end of the audit/appeal process (should the IRS select the taxpayer's return for an audit). However, taxpayers and practitioners need to consider Section 530 when determining a worker's status.
Requesting a Form SS-8 Determination From the IRS
Firms and workers may file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to ask the IRS to determine the status of a worker under common law rules. Most Forms SS-8 are filed by workers who think they are employees and therefore are entitled to employee benefits. In fact, 90% of Form SS-8 requests are filed by workers (U.S. Government Accountability Office, Employee Misclassification (Rep't No. GAO-09-717), available at www.gao.gov).
The IRS will acknowledge the receipt of Form SS-8 and then try to contact both parties to gather as much information as it can to make a determination. The case is assigned to a technician who will review the facts, apply the law, and make a decision. The IRS will then send a formal determination to the firm and worker (if it has enough information to make a determination).
The determination letter applies only to the worker (or class of workers) requesting it, and the decision is binding with the IRS. This means the payer/business doesn't technically have to do anything in response to the determination. However, it needs to carefully consider the findings because an employment tax audit could be looming.
Neither the Form SS-8 determination process nor the review of any records in connection with the decision constitutes an audit of a federal tax return. Because the determination is not an audit, audit appeal rights do not apply to it. If either party disagrees with a determination, it may request that the office reconsider it and provide additional information.
IRS Classification Programs May Reduce the Cost of Correcting Misclassifications
The Voluntary Classification Settlement Program (VCSP) was created by the IRS in 2011 to encourage taxpayers to come forward with worker misclassifications. If eligible, taxpayers will receive partial relief from retroactive federal employment taxes. Under this program, the employer pays 10% of the employment taxes that would have been due for the most recent year (as calculated under the reduced rates of Sec. 3509(a)). To apply for the program, taxpayers need to file Form 8952, Application for Voluntary Classification Settlement Program.
If a taxpayer is already in an employment tax audit, the IRS may present a Classification Settlement Program (CSP) closing agreement. The CSP operates much like the VCSP. (Review Internal Revenue Manual Section 4.23.6 for more guidance on the CSP.)
Due-Diligence Procedures and Considerations to Help Clients
Though worker classification may at times fall into a gray area of tax law, taxpayers should still observe these due-diligence procedures and considerations:
- Timely file information statements with the IRS: Even if a taxpayer classifies a worker as an independent contractor and the IRS during an audit later reclassifies that worker as an employee, having filed Forms 1099 means that the taxpayer can be eligible for various relief provisions that can significantly decrease the total liability owed. Failure to file information statements, on the other hand, bars the taxpayer from the various settlement programs and even obviates Section 530 safe-harbor relief.
- Document the intended relationship: Payers/businesses should keep contracts/employment agreements in each worker's permanent file. If there may be a debate on a worker's status, document the rationale and consider Section 530.
- Be aware of the trust fund recovery penalty for egregious situations: If intentional disregard of the rules is proven, and the IRS is unable to collect the employment taxes that should have been paid from the employer, an individual who is a responsible person for employment taxes for the employer could be subject to the trust fund recovery penalty. This penalty is equal to the full amount of the unpaid trust fund tax plus interest.
- Know that worker classification issues transcend taxes: Some recent cases, such as Berwick v. Uber, No. 11-46739 (Cal. Labor Comm'n 6/3/15), which found that a driver for the ride-sharing service Uber was an employee, not an independent contractor, showcase the many implications of reclassifying a worker as an employee. Pensions, reimbursements of expenses, PPACA requirements, and more are affected by the worker's classification.
Valrie Chambers is an associate professor of accounting at Stetson University in Celebration, Fla. Susan Allen is a lead technical manager with the AICPA Tax Division and is the staff liaison to the AICPA Tax Practice & Procedures Committee. For more information about this column, contact Prof. Chambers at firstname.lastname@example.org.