Worker misclassification is a hot topic now that the Obama administration’s Department of Labor is making proper worker classification a key area of enforcement. States are following this lead because improper classification deprives the states of revenue. Incorrect classification can lead to fines, penalties and litigation. Worker misclassification has historically been one of the highest areas of noncompliance for nonprofits. Therefore, nonprofits should take this opportunity to review how their workers are classified for tax purposes.
The IRS is utilizing a new National Research Project (“NRP”) audit program to examine compliance with employment tax reporting. The NRP began in February of this year and is expected to include 6,000 U.S. companies, both for-profit and nonprofit, over a three-year period. In addition to the NRP audits, the IRS will be conducting regular employment tax audits of about 60,000 employers annually. Arizona’s Department of Economic Security has also been extremely active in auditing worker classification this year.
Independent Contractor vs. Employee. There is a lot of misinformation surrounding the worker classification issue. Whether the employee works on site or off site, whether they have benefits, and how often they are paid are not determinative. The distinction between employee and independent contractor lies in the ability of the employer to determine how work will be performed. For identification purposes, an employee is generally considered to be anyone who performs a service for the employer if the employer can control what will be done and how it will be done. In contrast, an independent contractor is someone who follows an independent trade and offers their services to the public. The person for whom the services are performed has the right to control or determine the result of the work, not how that result is achieved.
The IRS and the Social Security Administration have developed a 20-factor test to assess the degree of control held by the person contracting for the services. These factors were published in Rev. Rul. 87-41, and were compiled from cases and rulings that considered the issue of worker classification. These factors are merely guidelines and the relative importance of each factor varies with the occupation at issue and the surrounding factual context. To the great relief of practitioners and nonprofits alike, the IRS issued a detailed internal training manual that breaks down the control analysis into three factors that hinge on behavioral control, financial control, and the relationship of the parties.
IRS 3 Factor Test. The IRS considers the following three factors in determining how a worker should be classified:
- Behavioral control. The first factor is whether the nonprofit has the right to direct and control how the worker accomplishes the task for which the worker is hired. If the nonprofit can direct how work will be accomplished, then the worker is considered an employee. However, if the worker is responsible for determining how work will be accomplished then the worker is an independent contractor.
- Financial Control. The second consideration is financial control; whether the nonprofit has a right to control the financial aspects of the worker’s job. This includes considerations such as how the worker is paid, whether expenses are reimbursed and who provides the tools/supplies. For example, a worker who provides his own tools and is not reimbursed for his/her expenses is considered an independent contractor whereas a worker who uses equipment supplied by the nonprofit is considered an employee.
- Relationship. Finally, the type of relationship between employer and worker is considered – are there written contracts or employee type benefits. If these sort of benefits exist (such as a pension or vacation pay) then the worker is considered an employee. In determining the classification of any worker, it is important for the employer to consider the degree of control. The more control the employer has over the worker; the more likely it is that the worker should be considered an employee. Conversely, the more independence the worker has, the more likely it is that (s)he is an independent contractor.
Consequences of Misclassification. Worker misclassification can result in the IRS holding the employer responsible for paying the back taxes of the worker. In order to prevent misclassification, it is helpful to follow a few guidelines. An employer should prepare a position description for employees, but for independent contractors, a contract with the employer describing the scope of the work is preferable. While this is helpful in order to prevent misclassification, it does not ensure that the IRS will agree with the employer regarding the worker’s classification.
IRS Help with Worker Classification. If an employer is unsure as to the proper classification of a worker, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding can be filed with the IRS. This form can be filed by a business or a worker. Upon receipt of this form, the IRS will review the facts and determine the worker’s status.
Section 503 Relief. Because it is possible that the IRS will not agree with the employer’s classification of workers, it is necessary for employers to ensure that they will meet the requirements for Section 503 Relief from employment tax liability. The three requirements are as follows:
- No Employee Treatment. First, the employer has not treated the individual as an employee and has not treated any other individual holding a similar position as an employee.
- Second, all federal returns filed by the taxpayer with respect to a worker are filed on a basis consistent with the treatment of the individual as an independent contractor.
- Finally, the taxpayer must have a reasonable basis for treating the worker as an independent contractor. A reasonable basis only exists if it is supported by judicial precedent, IRS rulings, a past IRS audit, or a long-standing practice of a significant segment of the relevant industry.
Essentially, if an employer treats the worker as an independent contractor in good faith and complies with the requirements set forth by the IRS regarding independent contractors, the IRS may still deem the individual an employee but the employer will be protected from financial liability. Therefore, at the very least, employers should ensure that individuals treated as independent contractors would meet the qualifications for Section 503 Relief in order to avoid consequences for misclassification.