Editor: Valrie Chambers, CPA, Ph.D.
The correct classification of workers as either employees or independent contractors is important because it affects not only how workers are paid but also how the government gets paid. Lately, worker classification has become a prominent issue due to the changing economic environment, technological revolutions, and recent legislative and administrative actions. The classification of workers can also affect the calculations of the Sec. 199A qualified business income (QBI) deduction, the amount of Paycheck Protection Program (PPP) loans, the amount of PPP loans that are forgiven, and the calculation of various employment credits (retention, family leave, and sick pay).
What is the difference and why does it matter?
In Publication 15-A, Employer's Supplemental Tax Guide, the IRS identified three categories of evidencethat are relevant in determining whether a worker is an employee or an independent contractor:
- Behavioral control: Whether the business has a right to direct and control how the worker does the task for which the worker is hired;
- Financial control: Whether the business has a right to control the business aspects of the worker's job; and
- Type of relationship of the parties: Facts that show the parties' type of relationship (e.g., the degree of permanency, whether employee-type benefits are provided).
Why does this matter? In a nutshell, workers who are employees receive a Form W-2, Wage and Tax Statement, and employers must withhold taxes from employee paychecks and remit them to the IRS on the employee's behalf. And not only income taxes are withheld: Employers must also withhold Social Security and Medicare taxes (together known as Federal Insurance Contributions Act (FICA) taxes). The FICA tax is 15.3%, of which the employer and employee each pay 7.65%. Then, there are the Federal Unemployment Tax Act (FUTA) taxes and state unemployment tax act (SUTA) taxes. In most states, only the employer pays unemployment taxes; they are not deducted from the employee's wages. The FUTA tax rate is 6%, but it is offset in large part by credits for SUTA payments.
It is easy to understand why businesses, from a financial perspective, might prefer having workers classified as independent contractors: The business would not have to withhold income tax and would not be liable for 50% of the FICA taxes and 100% of FUTA taxes for the worker. The reduction in benefit expenses is also substantial.
In addition, this determination affects the calculation of the Sec. 199A QBI deduction and, if the taxpayer obtained a PPP loan, the calculation of the amount of the loan forgiven and the amount of the loan. Remember that 60% of the PPP loan must be for payroll and related payroll expenses.
To help with the classification, workers (or firms) can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. When a worker or firm files Form SS-8, a formal determination is sent to them both and is binding with the IRS. State decisions are a separate matter.
Changing economies do not fit the mold
The traditional factors used to assess worker classification do not translate easily in today's economy, given how businesses are changing their models to offer different services to customers. The gig economy is expanding rapidly as internet platforms are used more to connect service providers to customers. The gig economy generally includes industries in which workers complete tasks on an on-demand or client-by-client basis, such as Uber and Lyft drivers or restaurant home-delivery services. The emerging gig economy has raised questions about how to classify workers for tax purposes. Tax practitioners should take care to inquire whether their individual clients are receiving income from a side gig, such as "occasionally" driving for Uber or Lyft, performing tasks for TaskRabbit, or perhaps paying independent contractors.
If so, make sure that receipts and other documentation are available for support. For business clients, inquire if they have filed the appropriate Forms 1099.
Legislation in play
Some states use some form of an "ABC test" (described this way because it has three prongs) to aid businesses in the classification of a worker. This is an ever-changing environment. California notably adopted an ABC test based on the state supreme court's 2018 holding in the case of Dynamex Operations West, Inc. v. Superior Court, 416 P.3d 1 (Cal. 2018). The decision established that companies must classify workers using a three-prong test. This test presumes that workers are employees unless the company that hires them can prove otherwise under the three rigorous prongs of the test: (1) the worker is free from the control and direction of the hirer in connection with the performance of the work; (2) the worker performs work that is outside the usual course of the hiring entity's business; and (3) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
In September 2019, California legislatively followed up on the state high court's decision with the passage of Assembly Bill 5 (A.B. 5), which was revised one year later in A.B. 2257. The legislation requires many companies that hire independent contractors to reclassify those workers as employees.
Some states have started to pattern themselves after California, and in the upcoming year many state legislatures may be engaged in renewed or new discussions regarding the gig economy.
In related federal news, on Jan. 9, 2020, the IRS issued news release IR-2020-04 and announced the launch of a new Gig Economy Tax Center (available at www.irs.gov) to help people involved in the gig economy meet their tax obligations.
Tax adviser responsibilities
As if the classification topic were not complex enough, another big aspect for CPAs to consider involves the ethics of advising clients about classifying workers. CPAs should keep in mind the potential for unauthorized practice of law when advising clients on worker classification if they have not been licensed or admitted to practice law in a given jurisdiction. Practitioners should check state rules to learn where all these situations occur and what CPAs can or cannot do regarding giving any advice.
Contributors Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Arthur Auerbach, CPA, CGMA, is an independent tax consultant located in Atlanta, specializing in tax consulting and estate and financial planning for individuals and closely held businesses. He is affiliated with the Asbury Law Firm as a consultant. He is a former member of the AICPA Tax Executive Committee and is a member of the AICPA Tax Practice and Procedures Committee. For more information on this article, contact firstname.lastname@example.org.
Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Arthur Auerbach, CPA, CGMA, is an independent tax consultant located in Atlanta, specializing in tax consulting and estate and financial planning for individuals and closely held businesses. He is affiliated with the Asbury Law Firm as a consultant. He is a former member of the AICPA Tax Executive Committee and is a member of the AICPA Tax Practice and Procedures Committee. For more information on this article, contact email@example.com.