Employee vs. Independent Contractor: The Importance of Proper Classification

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1 Employee vs. Independent Contractor: The Importance of Proper Classification Dominic L. Daher, MAcc, JD, LLM in Taxation Director of Internal Audit and Tax Compliance, University of San Francisco Dawn G. Mayer, JD, LLM in Taxation Tax Manager, University of San Francisco Joseph R. Irvine, CPA, MS, JD Development and Tax Counsel, The Ohio State University Joel Levenson Associate Director of Tax Compliance, University of Central Florida 2013 NACUBO TAX FORUM October 21, 2013

2 Overview Background Current IRS Classification Factors Evaluating Classification Factors Reporting and Withholding Consequences for Misclassifying Workers Obtaining Section 530 Relief Voluntary Classification Settlement Program Review of Different Worker Arrangements Contract Drafting Considerations Additional Resources 2

3 Background Worker classification continues to be a major focus in IRS audits IRS Employment Tax National Research Project audits of 6,000 employers IRS Voluntary Worker Classification Settlement Program eligible employers pay 10% of employment taxes due 3

4 IRS Classification Factors IRS 20 Factor Test published in 1987 (Rev. Rul ) IRS Training Materials -- updated categories and factors published in 1996: Behavior Control Financial Control Relationship of the Parties Current IRS website reflects Training Materials 4

5 Current IRS Classification Factors Behavioral Control: Does the university have the right to control how the job is done? Type of instruction given Degree of instruction Evaluation system Training 5

6 Current IRS Classification Factors-- Continued Financial Control: Does the university have the right to control the economic aspects of the worker s job? Significant investment Unreimbursed expenses Opportunity for profit or loss Services available to market Method of payment 6

7 Current IRS Classification Factors-- Continued Relationship of the parties: How do the university and the worker perceive their relationship to each other? Written contract Employee benefits Permanency of the relationship Regular activity of the business, i.e., university 7

8 Evaluating Classification Factors Per the IRS website, businesses must weigh all of the factors: There is no magic number that makes a worker an employee or contractor No one factor is determinative Factors relevant in one situation may not be relevant in another 8

9 Evaluating Classification Factors-- Continued Many schools use a checklist to evaluate the factors A properly completed checklist provides strong evidence on audit that the university reviewed the factors See University of San Francisco checklist 9

10 Evaluating Classification Factors-- Continued May have to evaluate another entity s classification factors. Entity who has control over payment of the wage is determined to be the 3401(d)(1) employer. Don t pay my firm, pay my employee directly. 10

11 Reporting and Withholding on Payments to Contractors Federal: U.S. payee -- Form 1099-MISC, no withholding if TIN obtained NRA payee -- Form 1042-S, 30% withholding unless treaty applies State: May be withholding and reporting obligations Example: California requires 7% withholding on payments to nonresident contractors 11

12 Federal Tax Consequences for Misclassifying Workers IRC Section 3509 Reduced Rates -- Available if Forms 1099 timely filed for workers: Employer share of FICA 7.65% 20% of EE's share of FICA 1.53 Income tax withholding 1.50 Total IRC 3509 Percentage 10.68% 12

13 Other Potential Consequences Affordable Care Act penalties State income tax withholding Disability insurances Unemployment insurance Workers compensation Benefits, including heath and retirement Minimum wage and overtime Interest and penalties 13

14 Affordable Care Act IRC Section 4980H shared responsibility/employer mandate provisions Fully effective in 2015 Rules apply to employers with at least 50 full-time employees Employer-employee relationship determined under common law rules If worker is classified as an employee and is a fulltime employee under the ACA rules, must offer affordable coverage under employer sponsored health plan 14

15 Affordable Care Act Part A Penalty ( 4980H(a)): Employer fails to offer health coverage to all full-time employees If employer fails to offer coverage to at least 95% of its full-time employees, will be subject to a penalty of $2000 x all full-time employees (minus 30) Part B Penalty ( 4980H(b)): Employer offers health coverage, but the coverage in not affordable 15

16 Part A Penalty Example: Affordable Care Act Whoopsie University offers 100 individuals it considers full-times employees affordable health coverage. Whoopsie treats its 10 public safety officers as independent contractors. Under the common law rules, the public safety officers are appropriately classified as employees (and as full-time employees under the ACA). As a result, Whoopsie has failed to offer at least 95% of its full-time employees affordable health coverage. Part A Penalty = $2000 x (110 30) = $160,000 16

17 Section 530 Relief Enacted as Section 530 of the Revenue Act of 1978 not part of the IRC Provides businesses with relief from federal employment taxes FICA, FUTA, and income tax withholding Not required to prospectively reclassify workers Does not terminate the worker s employment tax liability 17

18 Section 530 Relief--Continued Three requirements must be met to obtain Section 530 relief: Reasonable basis Substantive consistency Reporting consistency Not available for certain skilled workers hired through a technical services firm (e.g., engineer, computer programmer, systems analyst) 18

19 Reasonable Basis The business must have a reasonable basis for treating workers as independent contractors: Judicial precedent, PLR, TAM, etc. Past IRS audit of workers or similar positions Longstanding practice by a significant segment (25%) of the industry Other reasonable basis, e.g., independent legal advice 19

20 Consistency Requirements Both the substantive and reporting consistency requirements must be met for Section 530 relief: Consistent treatment of workers in question and similarly situated workers as contractors Consistent filing of Forms 1099 for all workers treated as contractors 20

21 Worker Classification Settlement Program Available if under audit Attempts to resolve case early in administrative process Series of graduated settlement offers depending on circumstances 21

22 Voluntary Classification Settlement Program (VCSP) Prospectively reclassify workers as employees Pay 10% of Sec liability for most recent tax year Must have filed all required Forms 1099 for each worker for the 3 preceding calendar years Must not be under employment tax examination by IRS or worker classification examination by DOL Form 8952 application 22

23 Example 1: Adjunct Faculty A full-time engineer worked as an adjunct faculty member for two universities: He was paid on a course-by-course basis over several years He taught on campus but otherwise worked from home communicating with students on He maintained a website devoted to his teaching activities The universities treated him as an employee but he challenged his status in Tax Court. 23

24 Example 1: Answer The Tax Court concluded the faculty member was an employee of both universities: Services as an adjunct professor were part of the regular business of the universities He bore no risk of loss from under enrollment He had worked for both universities continuously for several years His contracts treated him as an employee Beitel v. Commissioner, T.C. Summary Opinion, (2001) 24

25 Example 2: Computer Consultant A university hired a computer consultant to set up programs for statistical analysis: The work was performed at the consultant s business location He provided his own equipment and supplies The worker received no training on how to do the work He advertised his services and had other clients 25

26 Example 2: Answer The IRS ruled the worker was an independent contractor: The worker was responsible only for providing a finished product by a specified time He used his own facilities, equipment, and supplies Because of these expenses, he assumed the risk for a profit or loss He performed services for others PLR

27 Example 3: Physician A university hired a physician to provide medical care to students: The physician had her own private practice She worked on-call for the university clinic The physician received an hourly wage but no benefits There was no written contract between the physician and the university, which treated her as an employee 27

28 Example 3: Answer The IRS ruled the physician was an employee: The physician s services were integral to the clinic s functions The services were performed on the university s premises and subject to clinic protocols There was a continuing relationship even though the physician worked on-call The university had treated the physician as an employee PLR

29 Example 4: Hair Stylist A university hired a hair stylist to work in the campus barber shop: Per the contract, the worker incurred the costs of her license, equipment, and insurance The university set prices and the hours of operation The worker was required to wear a uniform She worked full-time for 6 months and received no benefits 29

30 Example 4: Answer The IRS ruled that the stylist was an employee: The worker was required to work set hours She worked 6 months, which indicated a continuing relationship Her services were integral to the function of the campus barber shop She lacked investment in facilities, indicating a dependence on the university PLR

31 Example 5: Law Student A firm hired a law student to provide part-time legal research and litigation support: The student set his own hours and decided where to work the firm, school, at home He was paid by the hour and received no benefits except for parking reimbursements The firm reviewed his work and signed all court filings he drafted The student did not have a contract with the firm 31

32 Example 5: Answer The IRS ruled that the student was an employee: His services were integral to the firm The student had no capital investment in an independent business or risk of loss The firm supplied the student with a computer and other office resources The firm had the right to direct and control the work There was no contract establishing the student s status The firm reimbursed the student s parking expenses TAM

33 Example 6: Off-Duty Officer A university requests several surrounding police agencies to assist with gameday security oncampus: The university and all police agencies have a mutual aid agreement, granting arrest powers The police agencies are assigned positions by the university, and the agencies implement a command staff to handle their assignment. The police agency assigns officers to work the game. 33

34 Example 6: Answer The IRS ruled that the off-duty officers were employees of the police agencies, however the university was required to report for tax purposes: Police agencies control their officer s University controlled the payment of wages Not independent contractors University paid agency for use of officer s equipment Issues were reported up through the officer s agency, not the university Solution is to pay the police agencies directly 34

35 Contract Drafting Considerations The following points should be considered in drafting an independent contractor agreement: Avoid employee language throughout the agreement Clarify that the worker requires no training Permit the contractor to use assistants in completing the work Limit the duration of the contract to a year or less The scope of work should be for a specific, finite project The end product should be stressed progress reports should not be required 35

36 Drafting Considerations--Continued Clarify that the contractor will not work exclusively for the university Permit the contractor to determine the place of work Payment should be made for work completed, not by the hour, week, month, etc. Clarify that expenses will not be reimbursed, including travel, equipment, supplies, etc. Termination of the agreement should require payment for work completed Avoid additional termination payments that reduce the risk of losses 36

37 Additional Resources Independent Contractor or Employee? IRS Training Materials IRS Website: Independent Contractor (Self-Employed) or Employee Employed/Independent-Contractor-(Self-Employed)-or- Employee 37

38 Questions

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