Employee or Independent Contractor:

New IRS Guidelines Can Pose Costly Tax Time Traps for the Unwary

IRS “20 Common Law Factors Test” is Revised as Standard for Determining Worker Tax Status 

The IRS’s revised criteria are a major departure from its long-standing “20 Common Law Factors Test” which has been used by businesses and individual taxpayers for several decades as the foundation for determining whether a worker is an employee or independent contractor.  For businesses, the answer determined whether they had to pay employment taxes to the IRS and employee benefits (for employees) or not (for independent contractors).  (If you look at tax-related publications prior to this year you’ll likely find the “20 Common Law Factors Test”).  Workers who were classified as employees received various employee benefits but felt Uncle Sam’s touch when it came to payroll deductions of income, social security and other taxes.  

The revised standards are based on three primary criteria: Behavior Control, Financial Control, and Type of Relationship between the employer and worker.  The overriding principal remains one of “control”.  Following is a brief overview of the new standard’s key elements: 

I.                     Behavior Control:  The more control an employer has over a worker’s behavior, the greater the chances it will be considered an employer-employee relationship. 

                            a)     Does the business have a right to direct and control how the worker does the task for which the                        worker is hired?

 Generally, the more control, the greater likelihood that worker is an employee rather than a contractor.

 b)     Does the employer have the right to control how the work results are achieved?

 If the business has the right to control the details of a worker’s performance she or she is more likely an employee. For independent contractors, the employer has likely given up this right,

 c) How much if any instruction does the business provide the worker?  

Employees are generally subject to business’s instructions about when, where and how to work, including where to buy supplies and services, what equipment to use, and what order to follow when doing the work.

 d)      How much training is provided?

 Employees usually receive training to perform a certain job in a certain manner, but not independent contractors (in the eyes of the Uncle Sam). 

II.    Financial Control: This includes various factors which show whether a business has a right to control the business aspects of the worker’s job, including:

                               1.      Reimbursement of business expenses
                           2.      Extent of worker’s investment
                               3.      Extent to which worker makes services are available to the relevant mark
                               4.      How the business pays the worker
                               5.      The extent to which the worker can realize a profit or loss (An independent contractor can make a profit                                         or loss. An employee cannot).

                      III.    Type of Relationship: This appears to be the proverbial “catch-all” category. Some factors considered by the                                  IRS in determining “type of relationship” are:

     1.   Written Contracts describing relationship parties intend to create

      2.  Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay.

      3.   The expectation of permanency of the relationship – is the worker hired with the expectation that the relationship will continue indefinitely rather than for a specific project or period?  If so, such expectation indicates an employer-employee relationship rather than independent contractor relationship. 

(In another revealing document discussed later in this Update, the IRS identifies “how long the person plans to work with your company” as “foremost” in the IRS’s determination of independent contractor status.  Referring to independent contractors who are hired to do work previously performed by employees, the agency says, “If you expect to work together indefinitely the IRS believes that you're creating what is really an employee relationship.”)

4.   The extent to which services performed by the worker are considered a key aspect of the company’s regular business. The more important they are to company business, the more likely (in the IRS’s view) the business will have right to direct and control worker’s activities, thus indicating an employer-employee relationshi

What This New Worker Status Test Means for Your Company

The IRS offers specific examples of how its new guidelines apply to various industry groups: Building and Construction, Trucking, Computer, Automobile, Attorneys, Taxicab Drivers, and Salespersons in its Publication 15A, Employer Tax Supplemental Guide, Revised January 2002).

Impact on Employee vs. Independent Contractor Classification: Avoiding Legal  Risks

A business which treats an employee as an independent contractor (for example, by    not paying                        employment taxes to the IRS) without any reasonable basis for this misclassification may be held                        liable for past unpaid employment taxes (including income, social security, welfare and other taxes                       not deducted from worker’s wages due to the misclassification) in addition to IRS penalties.

The legal risks may not end there.  Most worker misclassification case decisions (both those decided in favor of workers charging worker misclassification and those in decided against the plaintiff/workers) have been  based Courts’ application and interpretation of the IRS’s “20 Common Law Factors” test.  This includes the Microsoft class action case (settled for $97 Million including retroactive benefits for Microsoft’s misclassified workers), two landmark U.S. Supreme Court decisions (Nationwide Mutual Insurance Co. v. Darden and Community for Creative Non-Violence v. Reid) and various Federal Appellate Courts. These and other cases are discussed and analyzed in detail in the Section III of the Contingent Employment Law Manual.  The full text  of these significant Federal Appeals Court decisions are provided in the Contingent Employment Law Manual Supplement). 

IRS Form SS-8 Tells the Real Story

The most vivid illustration of this change in IRS policy can be seen in the content of the Form the IRS uses to for determining worker status for employment tax purposes, Form SS-8.  Employers and workers who want the IRS to make the decision about worker status for them complete this Form and submit it to the IRS for review. The current Form SS-8 includes questions under the three primary areas under the new guidelines: Behavioral Control, Financial Control and Type of Relationship. By comparison, the IRS’s previous Form SS-8 included instead various questions relating to the “20 Common Law Factors” test.

 What the New IRS Approach Really Means to Employers and their Workers – A View from the Courts

Several factors the "third prong" of this test, the "Type of Relationship" category have already been the subject of significant Federal Court decisions. For example:

 1. “Written contracts expressly stating the worker’s status”.

 This factor would lead you to believe that an employer who used a written contract expressly stating that a worker is an independent contractor can presume that the worker is an independent contractor. Yet many recent landmark Federal Appeals Court decisions, including the 9^th Circuit Court of Appeals in Microsoft, and at least 3 other Federal Circuit Courts have expressly rejected this argument when its was made on behalf of employers defending against worker misclassification claims.

 2. “Whether the business provides the worker with employee-type benefits”

 As in #1, Uncle Sam appears to be placing the cart before the horse. Most worker misclassification cases stem from the fact that misclassified workers  were not permitted to participate in their employer’s employee benefit programs. It can certainly be said that a business that provides a worker with employee-type benefits is treating the worker as an employee, not a contractor. However, our Courts have also made it very clear that failing to provide employee benefits to a worker is NOT evidence that the worker is an independent contractor instead of an employee, as Microsoft and other recent worker misclassification cases.

3. “Expectation of permanency”

 Given today’s economic insecurity, ongoing layoffs and corporate restructuring, you’d be hard pressed to find very many employers or employees who would say they have an “expectation of permanency”.

 Even the plaintiffs' attorneys in the Microsoft case emphasized that their clients were NOT “short-term temps”.  After the Microsoft decision, many companies followed Microsoft’s example by establishing a 365-day time limit when hiring temporary workers from staffing agencies. Perhaps this new policy is employers’ way of saying “we have no expectation of permanency when we hire temporary workers.”

However, this principal does not apply to companies that have transformed entire workforces from “employee” to “independent contractor” status while fully intending to keep them as permanent members of their workforce.  This was brought to light when the EEOC recently sued Allstate insurance Company $2 billion after Allstate converted its insurance agents from employees to independent contractors as part of its company-wide restructuring plan. The EEOC’s suit was time to coincide with various private class action lawsuits filed against insurance companies for similar workforce conversions.  For those who share my belief that we need an alternative to litigation, I suggest that effective education, information and training is the best answer to this kind of IRS policy change.

Education and Information is the Best Answer

I began this overview by observing how quietly the IRS revised its worker status criteria, and criticizing the lack of public explanation or focus on these important changes. The IRS’s failure to provide effective education and information should not stop everyone who is affected by these changes from educating themselves and informing their colleagues about them.  Lawyers and accountants need to learn what these revisions mean in order to properly serve their clients, particularly as we reach the height of Tax Season.  Small businesses who rely so heavily on a contractor workforce need to learn that the old rules have changed, what the new rules mean to them, and how they apply when hiring and managing their workers. 

Finally, we are all taxpayers in the eyes of Uncle Sam. The more you know about the IRS’s new rules the better off you’ll be when you need to decide “who’s the boss” at tax time. 

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