The issue of whether workers should be classified as employees or independent contractors for federal employment tax purposes has been a source of controversy for decades. The saga continues. This article summarizes a recent U.S. Tax Court decision on the classification of a manager in the home care industry.
Note: To make things more understandable in this article, I will call businesses that hire workers “employers” (whether the workers are employees or independent contractors), and I will call the individuals who get the job done “workers” (whether they are employees or independent contractors).
Why Worker Classification Matters
When a worker is properly classified as a common-law employee, the employer generally must withhold from the worker’s wages:
- Federal income tax (FIT); and
- The employee’s portion of the Social Security and Medicare taxes (FICA tax).
The employer must also pay the employer’s portion of the Social Security and Medicare taxes, pay federal unemployment tax (FUTA), file federal payroll tax returns, and comply with various IRS and Department of Labor (DOL) rules and regulations.
In addition, the employer may have to deal with state and local income tax withholding, pay state unemployment and Workers’ Compensation taxes, and comply with even more local rules and regulations. Handling all of this red tape can cost a bundle every year for each employee. If employee benefits — such as health insurance, paid vacations, and sick leave — are also provided, the cost of keeping a common-law employee on the payroll can become prohibitive.
In contrast, when a worker is properly classified as an independent contractor, the employer must simply provide the worker and the IRS with a Form 1099-MISC each year to report how much the worker was paid. That’s why many businesses prefer to treat as many workers as possible as independent contractors instead of employees.
Common-Law Employee vs. Independent Contractor
Common-law employees are workers considered to be employees (as opposed to independent contractors) based on various statutes, regulations, and court decisions. IRS and DOL rules can differ from state and local rules. That said, if an employer is allowed to treat a worker as an independent contractor under IRS rules, it will generally be the same across the board. Therefore, this article only discusses the IRS rules.
California Companies can refer to the Employment Development Department’s (EDD), Employment Determination Guide. The guide includes a worksheet on employment status that employers can fill out to determine the correct standing of employed individuals. The guide also includes some examples of independent contractors and common law employees.
Properly classifying a worker as an independent contractor is beneficial because the employer doesn’t have to worry about employment tax issues or provide expensive fringe benefits.
However, when an employer mistakenly treats an employee as an independent contractor, the employer could owe unpaid employment taxes, as well as interest and penalties. The employer also may be liable for employee benefits that should have been provided but were not. So, it’s important to get worker classification questions right.
Seven Factors to Decide Worker Classification
The Tax Court considers these factors when deciding whether workers should be classified as independent contractors or employees for federal employment tax purposes:
1. Degree of control. When an employer exercises significant control over how a worker performs duties or has the right to do so, this factor indicates employee status. When there’s little or no control or right to exercise it, this factor indicates independent contractor status.
Based on longstanding tradition, this factor is considered the most important. So, it’s often used as the tie-breaker in situations where there are an equal number of factors on both sides.
2. Investment in equipment and facilities. When the worker covers most or all of the cost of equipment and facilities used for the job, this factor indicates independent contractor status. For example, say the worker performs his duties out of an office in his home using equipment (computer, printer, and phone) that he pays for himself. In such a case, this factor would clearly indicate independent contractor status. On the other hand, if the employer provides most or all of the equipment and facilities, this factor would indicate employee status.
3. Whether the worker has an opportunity for open-ended profit or outright loss. A worker, who can make an open-ended profit through the strength of his or her own efforts, or alternatively, suffer an outright loss on the job, is likely to be an independent contractor rather than an employee. For example, this would be the case when an outside sales person is paid by commission only.
On the other hand, when the compensation arrangement dictates that the worker can only make a fixed profit and not suffer a loss, it indicates employee status. For example, this would be the case when the worker is paid a fixed amount for each day of work and the only significant job-related expense is the cost of commuting to and from the work site.
4. Whether the worker can be discharged. A worker who can be discharged is more likely to be an employee than an independent contractor.
5. Whether the work is related to the employer’s core business. When the worker’s duties relate to the employer’s core business it indicates employee status, while work related to a tangential enterprise indicates independent contractor status.
6. The permanency of the relationship between the employer and worker. Lack of permanency indicates independent contractor status, while permanency indicates employee status.
7. The relationship the employer and worker believed they created. If the employer and the worker believed the same thing at the time they entered into their arrangement, courts rule this factor can indicate either employee or independent contractor status, depending on the facts. If the parties believed two different things, this factor may be thrown out.
Facts of the Tax Court Case
In its recent decision, the Tax Court used the seven factors above to evaluate whether a worker who provided home care services to disabled clients was an employee. The taxpayer in this case, Atig Rahman, was hired by Ever Care Adult Care Services, which provides home and other care services to disabled adults. The taxpayer was quickly promoted to manager of a group home, where he worked about 40 hours per week and was paid at an hourly rate every two weeks.
Ever Care dictated the taxpayer’s duties and responsibilities, which included preparing a monthly financial forecast, hiring and firing staff, scheduling staff hours, meeting with officials from the Florida state licensing agency, maintaining and repairing the facilities, buying groceries for the home, assisting residents with personal grooming, and arranging transportation for residents. The taxpayer also met weekly with the owner regarding grocery purchases and gave the owner daily status reports.
Although Ever Care treated the taxpayer as a self-employed independent contractor and issued him a Form 1099-MISC, he did not pay any self-employment (SE) tax for the year in question. After an audit, the IRS claimed he was an independent contractor and issued an assessment for unpaid SE tax.
The Court’s Decision
The Tax Court analyzed these seven factors and found that none of them supported the self-employed independent contractor status:
The degree of control. The Tax Court found that Ever Care had the right to control the taxpayer’s work and did in fact exercise a high degree of control by:
1. Specifically enumerating his duties and responsibilities;
2. Specifying when and where his duties were to be performed; and
3. Requiring frequent reports to the owner.
Investment in equipment and facilities. The taxpayer did not provide his own equipment or facilities.
Opportunity for profit or loss. Ever Care paid the taxpayer at an hourly rate, so he had no open-ended opportunity for profit or loss.
The right to discharge. Ever Care retained the right to discharge the taxpayer and did, in fact, discharge him the following year.
Work related to the core business. The work performed by the taxpayer was an integral part of Ever Care’s core business of providing home care and other services to adults with disabilities.
Permanency of relationship. The taxpayer worked full-time for Ever Care for approximately nine months, at which point he was discharged. While it lasted, the relationship between Ever Care and the taxpayer was not thought to be temporary or short-term by either party.
The relationship between the parties. Ever Care treated the taxpayer as a self-employed independent contractor by issuing him a Form 1099-MISC and not withholding taxes from his pay. While this indicated that Ever Care intended for the taxpayer to be an independent contractor, this intention was self-serving because it allowed Ever Care to avoid paying employment taxes on his compensation and benefits.
Because all but the last factor weighed in favor of the taxpayer being a common-law employee, the Tax Court ruled that he did not owe self-employment tax because he was not a self-employed, independent contractor (Atig Rahman, T.C. Summary Opinion 2014-35).
While the Rahman decision was in favor of the taxpayer-worker, it opened the door for the IRS to go after the employer for unpaid federal employment taxes, interest, and penalties. Therefore, the decision is yet another cautionary tale that failure to properly classify workers can be an expensive mistake for employers. In many cases, proactive planning can lock in tax-saving independent contractor status for workers. But, if nothing is done before an IRS audit takes place, it may be too late to achieve the desired tax-saving results. Consult your tax adviser if you have questions about worker classification issues.