Categorizing workers as contractors or employees has major tax effects. If this important tax planning detail is overlooked, a business or a business person can be left with the tax bill of its workers.
Moreover, the difference in designations can result in significant compliance and overhead costs. The success of a business can depend on this designation; it is often worth the time and money to explore how to do things correctly.
Ultimately the principal to keep in mind when making a designation is the right to direct and control a worker as the agent of the business.
Below are some tax tips on how to qualify as an independent contractor (i.e. independent contractors vs employee taxes), this is not an exclusive list and we advise that a taxpayer consult a professional before taking this key step. Most of the considerations below are not determinative, but will support a determination that a worker is an independent contractor.
The Courts and the IRS will look beyond what is written in contracts and documents when exploring the ultimate question of control. They will seek testimony or other evidence of how the workers were actually treated. Naturally most employers will want control of their workers, but to maintain independent contractor designation the general idea is to not instruct, train, set hours of work, demand an order or sequence of work to be done, require meetings or briefings, and when possible to keep physical proximity between workers and those that hired them to perform. The analysis will vary with different industries and sometimes retaining some control may be necessary especially when the control concerns safety.
This one should be a no brainer; the word contract is in the word independent contractor. This is a very important factor and the lack of a contract is often the demise of a taxpayer. However, a contract is inherently an instrument of control because it defines promises and conditions to abide by. Therefore, a contract that establishes an independent contractor can set boundaries and definitions of work to be done, but at the same time often relinquishes control of oversight. Although more nuanced, the general idea is to describe what is to be done, but not to instruct as to when, where, and how it should be done.
For example, a contract for an independent contractor should not have a non-compete clause or covenants not to compete; rather a good idea may be to reiterate to a worker that they are free to work for others and even for competitors.
The idea is that an independent contractor has his/her own supplies to use for different employers not just one. If a worker relies on the supplies of the employer, they look more like an employee. Therefore to maintain independent contractor status, it’s advisable not to equip the workers with tools, supplies, materials, or sometimes even machinery to do the work. Providing automobiles for the workers is often a sign of employee status.
Moreover, do not reimburse the workers for use of their own equipment or for expenses in traveling or purchasing necessities for a project. These costs should be pre-negotiated in a lump sum rather than reimbursed as the job is being done. Again, the analysis can vary by industry and especially when the cost of doing the job is speculative and can fluctuate over an extended period of time.
If the worker has had a significant investment out of his pocket to do the job, the worker looks more like an independent contractor.
Setting a recurring fixed hourly, weekly, or monthly wage is inconsistent with how an independent contractor gets paid. Usually an independent contractor gets a lump sum which is partly determined ahead of time and can fluctuate based on unknowns that may occur in the future. An independent contractor could get paid on a regular basis for convenience, but the underlying price of their service should be based on the cost of a job to be done. A continuous reoccurring payment points to an employee relationship. Have your independent contractors submit invoices rather than having them clock in. Make sure they are being issued 1099s and not W-2s.
Also if the worker has a chance of gaining more or less money or a risk of losing money as a result of their services, they look more like independent contractors. For example, this could happen when a contractor overbids or underbids a job and makes more money than initially expected or accounted for in books.
Lastly, employees often get benefits not independent contractors. If the worker is allowed to participate in employee benefit plans under a tax-qualified plan, it is a strong indication that they are employees. Also non-qualified benefits like sick pay and vacation time is also indicative an on employee rather than an independent contractor. Similarly liability insurance for damages caused by a worker or payouts of such liability can be evidence of an employee.
The right to discharge a worker without having to pay them damages on the breach of a contract is indicative of an employee. The IRS and Courts will look to see if the looming and continuous threat of termination from a job was used to control a worker. An independent contract can be terminated also, but is usually pursuant to a defined deadline to get certain things done on time or terminated pursuant to the initial promises of the contract rather than on performance. For example, an employee may be terminated for showing up late to work on a daily basis, something an independent contractor should not be fired for when the work is getting done on a timely manner. However, an independent contractor could be terminated for an anticipatory breach of a contract when it is very imminent that the work promised at the outset will not get done. The analysis of this factor can be industry specific and can involve a sophisticated understanding of contracts law.
Courts will refer to workers as an integral part of a business when a business’s overall success and continuance relies heavily on the services provided by the workers in question. Courts have reasoned when the workers are integral to the business, they are necessarily subject to some degree of control. For example, if a struggling theater hires an entertainer to start performing on a regular basis and posts billboards everywhere promoting the performer’s show, the performer may be categorized as an independent contractor by courts or the IRS.
Give your independent contractors the right to delegate the work to an equally skilled worker if possible. The work will often not be delegated, but the right to do so could weigh in the favor of an independent contractor relationship.
A Taxpayer can Meet a Statutory Safe Harbor in Some Instances Commonly Know as Getting Section 530 Relief. If the Employer Qualifies for Section 530 Relief, the Independent Contractor Status of the Workers will be Ensured. The following Factors go to Help meet the Section 530 Relief.
Make sure you treat your workers as independent contractors on all tax returns and make sure you file 1099s for your independent contractors. Do not have them fill out a W-2. This is known as the “tax return” test for Section 530 Relief. For Section 530 Relief this is not just a factor, it is a requirement; whereas for determining status without Section 530 Relief, it is a factor and is not determinative.
If some similarly situated workers are treated as employees and others as independent contractors, the taxpayer can fail to meet the Section 530 Relief. Inconsistent treatment of similarly situated workers must be avoided. Inconsistent treatment can also hurt a taxpayer trying to obtain independent worker status without relying on the Section 530 Relief safe harbor as well.
This is the one factor that is often out of the control of the taxpayer except if they rely on a tax professional. Getting a Circular 230 Opinion or the advice of a professional can give a taxpayer reasonable basis to treat workers as independent contractors.
Other ways of establishing reasonable basis that are a result of circumstance are relying on a prior employment tax audit for the same business, proving an industry standard, or relying on judicial precedent, published ruling, technical advice memo, or a private letter ruling to the taxpayer specifically.
Both the Internal Revenue Service (IRS) and the Employment Development Department (EDD) have been aggressively auditing the issue of worker classification.
Mr. Abajian, a former IRS tax lawyer, has represented several clients before both the IRS and EDD on this specific issue. Before the EDD he represented a very high profile company that provided security services to celebrity clients such as Britney Spears, Brad Pitt and Lindsay Lohan as well as foreign diplomats. Mr. Abajian was able to show that the EDD Examiner was playing procedural games with the client. Eventually the case was taken before an administrative law judge where several witnesses testified and the case was ultimately resolved through a published opinion.
Mr. Abajian, has also represented several clients before the IRS in employment tax audits. All of these cases were resolved on favorable terms. In one case, Mr. Abajian represented the largest engineering firm in the world. He was able to broker a deal that saved the company substantial amounts of liability through the CSP program which is described briefly below. In another case, he was able to establish section 530 relief for one of the major loan brokerage companies in Southern California. He worked with industry specialists to prove that the industry standard was treated loan officers and independent contractors.
With the IRS, if an examining officer determines that a taxpayer may have erroneously classified a worker as an independent contractor, the agent could propose a classification settlement program. Usually this occurs when the taxpayer agrees to change the tax treatment of the employees moving forward and the IRS agrees to lowered assessments of 25% of the employment tax liability for the year when the taxpayer can prove they have filed Form 1099s for the workers at issue; and can make a colorable argument that they had a reasonable basis to do so and treated similarly situated workers the same. The IRS can even agree to forgo auditing certain other years that were never under investigation. The classification settlement program or CSP can be a worthwhile option for some taxpayers, if accepted the taxpayer must agree to a closing agreement. For other taxpayers it may be wiser to reject a CSP offer and preserve the right to administrative appeal and judicial review.
Please do not hesitate to contact Abajian Law to discuss worker classification issues. We have office in Glendale and in Orange County, Irvine.