Tax Monitor
Employee or Independent Contractor? That is the Question
February 11, 2016
The federal government continues to focus on what various agencies refer to as “misclassified” employees -- workers who should be treated as employees but whom the employer classifies as independent contractors. Many businesses prefer to utilize independent contractors rather than employees. With independent contractors, businesses are not subject to FICA/FUTA obligations, federal and state income tax withholdings, benefits obligations (including Affordable Care Act coverage and reporting), minimum wage, overtime and certain non-discrimination provisions.
Through the Internal Revenue Service (IRS) and United States Department of Labor (DOL), the federal government continues to commit significant resources (6,000 audits in 2010 and a budget of $25 million in 2011 to perform audits) to this issue. In 2011, the IRS and DOL entered into a Memorandum of Understanding according to which they would share information and collaborate in attempting to reduce the number of employees misclassified as independent contractors.
It is important to note that the process to determine whether one is an employee or independent contractor is not the same for all federal purposes. The toughest standard is under the Fair Labor Standards Act (FLSA) which is administered by the DOL’s Wage and Hour Division. Under the FLSA, a “suffer or permit” or “economic reality” standard is statutorily incorporated in the Act. It is the economic realities of the worker’s relationship with the employer which control the determination. The key factors under the economic reality standard are:
- Whether the work is an integral part of the employer’s business
- The worker’s opportunity for profit or loss depending on his managerial skill
- The relative investments of the employer and worker
- Whether the work requires special skills and initiative
- The permanency of the relationship
- The degree of control exercised or retained by the employer
The DOL takes the position that the “control” factor (which is key in the common law determination) should not be given undue weight, but rather the factors should be considered in totality to determine whether the worker is economically dependent on the employer and thus an employee.
In Administrator’s Interpretation No. 2015-1 issued on July 15, 2015, the DOL elaborated on the factors to be considered, but concluded “… most workers are employees under the FLSA’s broad definitions.” The “suffer or permit” test has also been applied under Title VII, the Age Discrimination in Employment Act and the Americans with Disabilities Act.
In Nationwide Mutual Insurance Co. v. Darden, the Fourth Circuit held that due to the remedial purpose of ERISA, an employee for purposes of ERISA is someone who has reasonable expectations that he will receive benefits, relied on that expectation and lacked the economic bargaining power to contract out of the forfeiture provisions of his employer’s plan. The Supreme Court rejected this analysis holding that where a federal statute does not specifically define “employee”, courts should apply the common law test. Under the common law test approved by the court in Nationwide:
In determining whether a hired party is an employee under the general common law of agency, we consider the hiring party’s right to control the manner and means by which the product is accomplished. Among the other factors relevant to this inquiry are the skill required; the source of the instrumentalities and tools; the location of the work; the duration of the relationship between the parties; whether the hiring party has the right to assign additional projects to the hired party; the extent of the hired party’s discretion over when and how long to work; the method of payment; the hired party’s role in hiring and paying assistants; whether the work is part of the regular business of the hiring party; whether the hiring party is in business; the provision of employee benefits; and the tax treatment of the hired party.
This common law test is used by the IRS and also has application (in addition to ERISA and the Affordable Care Act) to the National Labor Relations Act and the Immigration Reform and Control Act. In articulating the common law test, the IRS has modified its position over the years. In Rev. Rul. 87?41, the IRS set forth a twenty factor test. More recently, the IRS has stated that it is the degree of control and degree of independence which will determine the relationship and that these factors fall into three categories: behavioral control, financial control and the type of relationship of the parties. See Publication 15-A, Employer’s Supplemental Tax Guide. While in Publication 15-A the Service discusses the three factors in some detail, there is no substantive difference in the factors outlined by the IRS and the common law test articulated by the Supreme Court in Darden.
Several courts have attempted to merge the “suffer or permit” test with the Darden common law test, noting that both the economic realities of the relationship and the right to control are critical factors. See Diggs v. Harris Hospital-Methodist, Inc.
There is no “one size, fits all” approach. Just because an employer is comfortable that an individual is not an employee because of its lack of control, does not make it so. In Donovan v. DialAmerica Marketing, Inc., the court found that “home researchers” who had signed an independent contractor’s agreement, whose jobs were to look up phone numbers of potential magazine subscribers, who were given a box of 500 cards with the expectation that they would be returned within a week, and who received no day-to-day supervision were nevertheless “employees” for purposes of FLSA. It is likely that these individuals would not be common law employees due to the fact that they worked from home, controlled the hours that they worked and had the week-by-week ability to decide whether or not they worked.
If an employer treats all of its workers as “employees”, they have little to worry about. If there is a segment of the workforce treated as independent contractors, we suggest you contact an attorney discuss. The IRS will make the determination upon request of the employer or employee if either files Form SS?8. However, this is not necessarily the recommended approach, and instead Form SS?8 can serve as an excellent worksheet for the employer’s (or attorney’s) analysis of how employees should be classified
If the employer concludes that a segment of its workforce is misclassified or believes it is too close to call, the IRS sponsors the Voluntary Classification Settlement Program (VCSP). Under this program, employers can voluntarily elect to treat certain workers as employees going forward. VCSP requires that the employer pay a fee of 10% of the employment tax liability which would have been due for the prior year had the group of workers been classified as employees in that year. This is just a fraction of what the employer could have been assessed upon audit. The actual amount of this fee can be calculated on Form 8952.
Employers should anticipate more resources being directed by the federal government to this issue in the future as the employee vs. independent contractor distinction will continue to have significant meaning for benefits like the affordable care act and ERISA based benefits.
This article was written by Michael D. Foster, an attorney with Jackson Kelly’s Tax Practice Group and Assistant General Counsel to the Firm.