3 Ways to Determine ‘Contractor vs. Employee’ Classification

Published: Mar 25, 2019
Topics: Tax
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Across most industries and entity structures, companies hire independent contractors. While the advantages may seem obvious — notably, not having to pay FICA and unemployment taxes — businesses may face significant tax and legal exposure if worker classification fails to hold up under a federal or state challenge.

As settled court cases have shown, workers claiming to be misclassified as an independent contractor over employee status may sue the company for inclusion in employee benefits, such as bonuses, vacation, insurance benefits, and employer-sponsored retirement plans. Even if a company avoids litigation, the IRS is always lingering. A common IRS request in a tax audit is to review a company’s general ledger where contractor services are noted — for example, as “professional services” or “outside services.”

Substantial and recurring payments to a consultant may, on their face, suggest an employee relationship. Any determination of misclassification can imperil qualified benefit plans like pensions, which hold strict anti-discrimination rules and trigger additional plan contributions including potential penalties.

A written contract in itself is not a complete safeguard. While a company may document a worker as an independent contractor, the IRS looks at substance over form in analyzing employee relationships by virtue of a 20-factor checklist. The ultimate measure of these guidelines is influence and control, but it also extends to type of work, hours spent, and frequency of the work.

Common Law Test

Unless a business has convincing proof to the contrary, the IRS may view a person performing services for the company as an employee.

With challenges on the rise, companies should review the following general three-pronged test — spanning behavioral, financial, and relationship considerations — to gauge whether the claim of independent status is a sustainable tax position.

Who controls the worker’s schedule?
Claims of independent status may be questioned where consultants do not set their own schedules or use their own supplies and office equipment to perform the work. While a company may delineate expectation of end-product delivery, any ongoing training and instruction by the company as to how and where the work is performed suggest employee status.
How often is the worker paid?
Similarly, a worker receiving steady compensation for an extended time period also implies an employee engagement. By contrast, a consultant is paid by the job, based on a specified fee arrangement. Further, with a flexible schedule, a contractor can pursue additional work opportunities and write off business purchases related to performance of the work.
What is the extent of the relationship?
The business should ensure contracts spell out the nature of the relationship. However, since substance prevails, any open-ended engagement will undercut claims of independent contractor status. The same holds true where the worker’s duties are critical to daily ongoing business operations.

Finding a ‘Safe Harbor’

If, in reviewing the above points, a business realizes current classification may be problematic, there are options. The safe harbor provision, under Internal Revenue Code Section 530, allows a business to sidestep classifying workers as employees if they meet certain criteria.

First, the business must demonstrate a “reasonable basis” for not treating the workers as employees from the time they are hired — as precedent. For example, the business may cite a related court case or a previous IRS audit where the same classification passed review. The business may also demonstrate that the current classification is a common industry practice or that a professional services expert advised the business on the current classification.

When using independent contractors, businesses may also find defense in consistency. For example, a business can make an argument if it has always treated workers as independent contractors. Similarly, the business must always have filed requisite tax forms for individuals as independent workers versus employees.

Separately, businesses unsure of how to proceed can seek an IRS determination by filing Form SS-8. However, the application process is both time-intensive and does not guarantee a favorable outcome.
As an immediate best practice, a business should consider engaging a tax professional to provide proper guidance in this area. The right expert will lay out the relevant facts and provide the technical merits behind each scenario, so that a business can wisely proceed in hiring (and classifying) workers.

Business Tax Quarterly - Spring 2019