Be sure to label your workers the right way
The long-running controversy over properly labeling employees and independent contractors shows no signs of easing. A recent Department of Labor study revealed a whopping 30 percent of businesses “misclassified” employees as independent contractors. A Senate committee hearing labeled the misclassification problem as “staggering.”
Although the Government Accountability Office, the investigative arm of Congress, acknowledges that employee misclassification itself is not a violation of law, far too often it is associated with labor and tax law violations.
The Internal Revenue Service (IRS) is in the midst of a comprehensive National Research Program (NRP) of Payroll Audits aimed, in part, toward catching employers that fail to or improperly withhold taxes and pay Social Security and Medicare premiums on the wages of workers misclassified as independent contractors. Many states are also, reportedly, moving on the misclassification issue as well.
Who is and who isn’t
The IRS uses three characteristics to determine the relationship between businesses and workers (behavioral control, financial control and type of relationship). Misclassification as a nonemployee can result in liability not only for employment taxes, but also for the 100 percent penalty for failure to collect and account for employment taxes.
At its most basic, the employee-independent contractor controversy boils down to the argument that by labeling a worker as an independent contractor rather than an employee, an employer can avoid the voluminous paperwork and payroll tax burden. For example, a worker who is an independent contractor can exclude certain types of compensation from income and deduct more work-related expenses than they could as an employee.
Although the term “independent contractor” is not clearly defined in tax laws, it is no secret that self-employed and independent contractors contribute greatly to the ever-increasing “tax gap,” the difference between the taxes owed and the taxes actually paid.
In addition to the IRS’ worries about the timely payment of income taxes when an employer is not in the picture, the U.S. Department of Labor frets about misclassified employees unfairly excluded from coverage under key laws designed specifically to protect workers.
Relabeled as employees
It is not always a bad deal for an independent contractor relabeled as an employee. A worker may receive employee fringe and pension benefits; may be entitled to reimbursement for business expenses; may be entitled to federal and state minimum wage and hour standards; and may receive coverage under nondiscrimination laws, unemployment insurance and workers’ compensation protection. Several years ago, the IRS published guidance for workers paid as independent contractors relabeled as an employee. What should the worker do?
- Tax returns and amended returns: A worker may have received a Form 1099 and had no reason to report the amount as wages. However, if, after filing a tax return, the IRS determines the worker is an employee, the worker must file an amended tax return. In all likelihood the reclassified employee was overpaid because of the self-employment tax (which is the equivalent of paying both the employer and an employee’s share of FICA).
- Schedule “C” expenses: Most independent contractors include all their income and expenses from their independent contractor business on Schedule C of Form 1040. The bottom line of Schedule C is the net taxable income from the business. For someone who has been reporting independent contractor income on a Schedule “C”, the relabeling can be messy.
- Changing returns: According to the tax rules and the IRS, when an independent contractor is relabeled as an employee the expenses deducted from income on Schedule C must now be deducted as miscellaneous itemized deductions, subject to a 2 percent floor. What’s worse, some of the expenses may no longer be deductible, such as the deduction equal to one-half of the amount of self-employment tax.
- Do it yourself or have it done for you: According to the IRS, a reclassified worker taking the initiative to correct matters, usually with an amended tax return, may be able to reduce or avoid any otherwise applicable interest or penalties on taxes due. The reclassified worker might, in fact, receive a refund of any overpayment of tax. For those who did not initially pay FICA or self-employment taxes, paying it now will ensure credit for this income with the Social Security Administration.
A safe harbor from morphing liabilities
An employer’s liability for violations of wage and hour laws, discrimination, wrongful termination and similar rules can be easily minimized by not having employees or keeping their ranks to a minimum. As some businesses have discovered, it is usually possible to have some workers operate as independent contractors, thus sidestepping a panoply of tax and other liabilities – maybe.
Created in 1978, Section 530 of the Tax Code provides relief from reclassification liabilities when an employer misclassifies workers. More than 30 years after this “temporary” provision was enacted, it continues to be interpreted liberally, providing protection when an employer has classified a worker as an independent contractor and the worker is reclassified on audit. The employer is relieved of liability if the tax returns, including Forms 1099, show that all similar workers were consistently treated as independent contractors, and there was a reasonable basis for that classification. Employers must usually satisfy three requirements: a reasonable basis for treating the workers as independent contractors; a substantive consistency requirement; and a reporting consistency requirement.
The IRS admits it has the resources to detect and pursue only a tiny fraction of misclassification situations. In fact, the latest figures available from the IRS’ Small Business and Self-Employed Division reveal the agency completed examinations of fewer than 1,200 employers. However, it only takes one unemployment insurance “employee” determination to lead to one on workers’ compensation, state disability, IRS issues, etc.
Fortunately, the IRS has Form SS-8, a streamlined ruling form that either workers or an employer can fill out to obtain an IRS determination on worker status. Although the SS-8 program is helpful, there is some risk involved. In fact, 72 percent of all Form SS-8 requests the IRS received resulted in determinations that the workers in question were employees; twenty-five percent were closed without any advice given. Only 3 percent resulted in determinations that the workers in question were independent contractors. Surprisingly, about 90 percent of these requests are filed by workers, which could explain the skewed numbers.
Relief is just a provision away
The most fundamental difference between employees and independent contractors is that employers have the right to tell employees what to do and how to do it. No turf care professional striving for independent contractor status, however, should ask for or accept instruction or order about how to do their job.
If someone runs absolutely no risk of loss, they are not really an independent contractor. This can be as simple as charging a set price for a job or engagement. If the project price exceeds expenses, an independent contractor will make money; if too little is charged, a loss will result.
Independent contractors don’t accept employment benefits; instead, they charge enough so health insurance, paid vacations or pension benefits are affordable. Independent contractors also find it is a good idea to maintain a separate bank account. Most importantly, an independent contractor should make their services available to more than one person/company.
The battle rages on
The potential liability for mischaracterization of workers is already frightening, and it may become even more expensive. The Obama administration proposed to reform the IRS’ oversight of worker classification in its fiscal year 2011 budget proposals.
There are also proposals to make misclassification penalties more severe for both employers and workers, as well as give more power to the government in cases of misclassification. There are increased audit programs (such as the three-year – National Research Program’s Payroll Audits) designed to ferret out problems, and more employers of all sizes are destined to face such battles.
Short of treating everyone as an employee, there is no easy solution to this problem. It is clear that many businesses do not routinely examine worker relationships before they are confronted with an audit (IRS, Labor Department and more), and workers rarely look beyond the anticipated tax breaks when assuming the independent contractor label.
Mark E. Battersby is a tax consultant in Ardmore, Pa., as well as a freelance writer specializing in business and tax issues.