Independent Contractors versus Employees – Worker Classification for Tax and Employment Purposes
It is increasingly important for companies to understand the difference between employees and independent contractors and the consequences of each classification. Uber recently paid $100 million to the state of New Jersey in a classification fight over whether drivers were properly classified as employees or independent contractors. This type of classification dispute is not limited to drivers. Recently, agricultural, retail, contracting, consulting, health care, manufacturing, insurance, and financial services industries have seen a rise in worker classification audits. This raises the question, how are worker classifications determined in the context of tax and employment law?
An employer’s choosing to label a worker as an “independent contractor,” as opposed to an “employee,” does not make it so. For both federal and state tax purposes, worker classification inquiries go well beyond the label. As with employment law, worker classification for tax purposes depends on a complicated, fact-intensive analysis, in which revenue agencies generally favor an employer-employee relationship. The consequences of misclassifying an independent contractor can be costly.
Companies that hire independent contractors are not obligated to withhold income taxes or employment taxes (such as Social Security and Medicare) or pay the employer share of employment taxes and unemployment insurance. This may give rise to a classification tax audit. To be prepared for a classification tax audit, it is important to conduct an internal review of worker classification (preferably by a CPA) based on the tests that are used by the IRS and various state revenue agencies. Generally, states apply an analysis that focuses on the relationship between the company and the worker, and in particular, the level of control the company can exert over the worker. Whether for tax or employment purposes, it is important to understand the various tests and considerations that determine a worker’s classification as an employee or an independent contractor.
Common Law/Multiple Factors Tests (Federal and Majority of States)
Both the Internal Revenue Code and many state definitions of “employee” revenue agencies rely on common law definitions. Over time, these definitions have evolved into multi-factor tests, with factors categorized into three groups: behavioral control, financial control, and relationship. No one factor is determinative and certain factors may weigh more heavily, especially as to certain categories of workers.
Behavioral Control
Factors in the behavioral control category consider whether the company has the right to control the manner and means in which a worker performs services. The focus is on whether the company can exert control over how a service is performed, not simply on the final product. For example, can the company require the worker to use certain tools or to follow a specified method, or is the worker highly skilled and exercises his or her own expertise in executing the contract to deliver an agreed outcome or result?
Financial Control
This category considers certain financial aspects of a worker’s job. For example, is the worker able to negotiate the contract fee, does the company provide materials and equipment, or can the worker offer services to competitors and/or the public? Financial control also contemplates whether the worker has any financial risk in accepting the contract and whether he/she can make a profit or recognize a loss.
Relationship
The final category assesses how the company and worker perceive their relationship. For example, if there is a written contract, what does it say? (Be aware that simply labeling a worker an independent contractor does not prove the worker actually is one for tax purposes). Does the worker receive typical employee benefits, such as insurance or sick pay? How permanent is the relationship, i.e., does the relationship last for a specified period or indefinitely?
ABC/Modified ABC Tests (Minority of States)
Under the ABC test (cleverly named after the three factors—a, b, and c), a worker is an employee unless three conditions are all satisfied:
(a) the worker is free from the control and direction of the employer in connection with the performance of the work, both under the contract and in fact,
(b) the worker performs work that is outside either
(1) the usual course of the employer’s business or
(2) the employer’s places of business, and
(c) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Generally, this is a challenging test for workers to pass. The “Modified” ABC test (used in California) is even more challenging. Under the Modified ABC test, performing work outside the employer’s place of business is insufficient to allow a worker to be classified as an independent contractor.
Conundrum
Unfortunately, the tests for federal versus state and for tax versus worker’s compensation/unemployment insurance do not always match. For example, in a state that uses the federal or common law test for tax purposes, and a Modified ABC test for unemployment insurance purposes, a worker may be an independent contractor for tax purposes and an employee for unemployment insurance purposes. Or, even worse, in a state that uses the Modified ABC test for state tax purposes, a worker may be an employee for state tax purposes but an independent contractor for federal tax purposes under the federal multi- factor test. In many states, therefore, companies should think about whether it makes sense to classify workers differently for one purpose or another.
Employment
Worker classification also determines whether a worker is entitled to protection under state and federal employment laws such as wage and hour, immigration, human rights (discrimination and harassment), labor relations, and workers’ compensation. State legislatures and federal and state agencies are increasingly focused on ensuring that employers are not denying workers the protections of these laws.
In the employment context, improperly classifying a worker can result in liability under federal and state law for overtime pay, denial of meals and rest breaks, harassment, failure to accommodate disabilities, workers’ compensation, unemployment compensation, and denial of benefits, to name a few. With recent increases in union organizing, there is also a renewed focus on the rights granted to employees under labor relations laws.
In many cases, a worker may prefer to have flexibility and request to be a contractor. However, a worker’s preference is not determinative of actual classification. Government agencies often presume (though often wrongly) that each worker is an employee unless that worker has a separate legal entity which actively does business with others. To properly document a worker’s status, companies should require written contractor agreements with terms that meet the tests discussed above. Generally, it is helpful for the agreement to have a fixed term. It is also important to monitor contractor relationships to ensure that the day- to-day operations are consistent with the terms in the agreement. Further, government agencies look more favorably on relationships in which contractors do not use company offices or equipment, do not have system access, and do not receive any type of employee benefits. Contract terms and relationships that reflect these terms can bolster contractor status and decrease risk.
Risks of Contractor Misclassification and Tips to Avoid Liability
Worker classification audits are on the rise. This is particularly true in the tax context, where revenue agencies see millions of dollars, if not billions, left on the table due to misclassification.
In addition to the obvious tax expense (including interest and penalties), worker classification audits are time intensive, costly, and disruptive. An audit may start with the IRS or state revenue agency requesting documents and information from the business (including conducting in-depth business interviews) and then sending written questionnaires to workers that the business has identified as independent contractors. Similarly, state agencies with responsibility for protection of employee rights may seek detailed information about contractors and employees for a very broad time period and then conduct interviews similar to those conducted by the taxing authorities. Audits in the employment context also can result from a worker complaint about pay, an injury on the job, or an unemployment claim. Similarly, an employee who is subject to discrimination may attempt to claim employment status.
Once an audit is complete, state revenue agencies may reclassify certain categories of workers or specific workers and assess tax and penalties. Additionally, state agencies often report reclassifications to the IRS, which may result in the business paying more taxes and penalties. Moreover, state agencies often report classification issues to one another, which can result in even more audits and penalties. In short, audits by one agency can balloon into audits by several agencies, costing businesses a significant amount of time and money.
Tips
In summary, businesses should be aware of the following:
- Labelling a worker as an “independent contractor” does not determine the worker’s status.
- An employee’s preference of contractor versus employee is not determinative.
- Federal and state agencies presume workers are employees.
- To be prepared for a worker classification audit, be proactive and conduct your own internal review of all independent contractors (preferably a review protected by attorney-client privilege).
- Know the worker classification rules of a state before you permit a worker to live and work there.
- If audited, be aware that an adverse determination by one agency can balloon into audits and money owed to many other agencies. Be careful in business interviews and consider whether requesting Section 530 relief, a federal safe harbor provision, would be appropriate.