As the IRS intensifies its scrutiny of worker classification, businesses may want to take a fresh look at how their policies, procedures, and documentation around engaging independent contractors might withstand IRS review.
While the worker classification issue never seems to go away, for most businesses it has been on the back burner for more than a decade. In 1996, the IRS—recognizing that changes in the way businesses were operating would affect the relevance of the common law factors traditionally used to classify workers, and after seeking input from the public—revised the training for its revenue agents (IRS, “Independent Contractor or Employee?” Training 3320-102 (10-96) TPDS 84238I). Examiners were encouraged to consider the entire relationship between a business and a service provider and to understand that as long as the rules were followed, businesses legitimately could use independent contractors.
During the same period, the IRS launched its Classification Settlement Program (CSP), which provides a standard settlement agreement for use if examiners determine that workers are misclassified. The settlement program, which is still in place, can be quite useful to taxpayers. In most cases, if a business agrees to begin treating the workers in question as employees prospectively, a tax assessment is made for only one year, rather than for all years of the examination. Moreover, the tax rate used for this assessment, assuming the misclassification was not a matter of intentional disregard, is less than the usual federal income tax withholding and FICA rates.
These initiatives likely helped the IRS clear its backlog of highly contentious worker classification cases. However, given recent developments, it is clear that the worker classification issue will again be a high priority for the IRS. Worker classification started receiving increased attention when the GAO reported in May 2007 that underreporting of income by self-employed individuals makes up 43% of the tax gap—the difference between the tax that is owed and the actual revenue collected. The report also stated that 15% of employers misclassify workers, resulting in an estimated annual revenue loss of $4.7 billion.
Further, in July 2007, the Senate Appropriations Committee urged the IRS to increase enforcement in the area of worker classification. As a result, the IRS chief of employment tax indicated that worker classification cases will be a major IRS focus in 2008. Most recently, the IRS issued new Form 8919, Uncollected Social Security and Medicare Taxes on Wages, to be filed by individuals who believe they are employees but who were improperly treated as independent contractors.
Identifying the correct status of a service provider as an employee or independent contractor for federal tax purposes depends on application of common law standards, which can be unclear and often seemingly contradictory as applied to the facts and circumstances of particular businesses. The key question is whether the service recipient has the right to direct and control the service provider.
The employment tax regulations provide that an employer-employee relationship exists when the business for which the services are performed has the right to direct and control the worker who performs the services. This control refers not only to the result to be accomplished by the work, but also to the means and details by which that result is accomplished. Thus, the very nature of determining whether a worker is an employee or an independent contractor is both subjective and fact intensive.
As a practical matter, independent contractors are subject to some constraints, while employees enjoy some autonomy. Control, therefore, is a matter of degree. All relevant facts are weighed to determine whether an employer-employee relationship exists. Before the release of its training materials in the mid-1990s, examiners relied on Rev. Rul. 87-41, which described what are usually referred to as the “20 common law factors.” While not abandoning the 20-factor test, the training materials offered a new approach to the evaluation. Examiners were trained to look to certain categories of evidence to better understand the relationship.
Behavioral control: “Facts which illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is engaged” (IRS Training 3320-102, p. 2-7). Indicators of behavioral control include instructions and training.
Financial control: “Facts which illustrate whether there is a right to direct or control the business aspects of how the worker’s activities are conducted” (id.). Indicators of financial control include significant investment, unreimbursed expenses, services available to the relevant market, method of payment, and opportunity for profit or loss.
Relationship of the parties: “Facts which illustrate how the parties perceive their relationship” (id.). Indicators of the parties’ relationship include intent of the parties (often embodied in written contracts), employee benefits, discharge/termination, and regular business activity.
Even if a common law analysis would indicate that a service provider is an employee, the business may be able to rely on relief provisions of Section 530 of the Revenue Act of 1978 and continue to treat the worker and those working under similar fact patterns as independent contractors. The IRS has instructed examiners that eligibility for relief under Section 530 must be actively considered at the beginning of an examination (id. at i). The business must meet the consistency and reasonable-basis requirements before the Section 530 relief provision applies. Under the consistency tests, the business must have filed required Forms 1099 (reporting consistency) and must have treated all workers in similar positions the same (substantive consistency). Also, in making the determination to treat the service provider as an independent contractor, the business must have reasonably relied on one of the following: the prior audit safe haven, the judicial precedent safe haven, the industry practice safe haven, or some other reasonable basis. Meeting the consistency and reasonable-basis tests may give the business relief from federal employment taxes, both retroactively and prospectively, with respect to the workers whose status is in question.
Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
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