Employee vs. Independent Contractor
Whether to treat an individual who provides services in your trade or business as an employee or independent contractor is a question often raised by business owners. It is also of serious concern to the IRS, EDD and other State tax agencies.
Employers, given a choice, might prefer to pay someone as an independent contractor as it saves them from having to pay the employer’s share of FICA, Medicare, FUTA and other taxes. Further, other benefit programs that are for the benefit of employees may not apply to independent contractors (non-employees), saving the employer even more money. Worker’s compensation liability is typically based on employee earnings, and not those of independent contractors.
For the individual receiving compensation, their take-home pay as an independent contractor is the gross amount of their compensation. They typically file a Schedule C (self-employed business schedule) on their tax return, and report the gross receipts less any business expenses incurred in earning those receipts. The independent contractor is responsible for paying their social security and Medicare taxes (called SECA) and their state and federal income taxes. The SECA and Medicare costs are twice what they would have paid as an employee. Further, an independent contractor typically loses certain rights such as access to employee benefits (health insurance, vacation pay/time, etc.).
What is important to understand is that the tax agencies will look to the actual working relationship between the company/employer and the individual performing services and getting paid for those services. Regardless of any agreement between the parties (such as an independent contractor agreement), if the actual relationship is employer-employee, then the employer can be required to pay all of the taxes that should have been withheld from the employee, plus the employer taxes, and likely some penalties as well.
Consequently, whenever someone is “hired” to provide services to a company, the nature of those services must be evaluated in connection with the “20 common-law factors” that the IRS uses to determine if an employer-employee relationship exists. If the company makes the decision to pay the individual as an independent contractor, the company may wish to consult an attorney. The purpose for this will be to draw up an agreement to enable the employer to easily recover from the “employee” the employee’s share of income tax, FICA and other amounts that should have been withheld – if a tax agency makes a determination that an employer-employee relationship exists.
The bottom line is that under common law, a worker is an employee if the person for whom they work has the right to direct and control the way they work, both as to the final result and as to the details of when, where, and how the work is to be done. It is the IRS view that the employer need not actually exercise control. It is sufficient that they have the right to do so. Here are the 20 factors the IRS (and EDD) consider:
- Is the person providing services required to comply with instructions about when, where, and how the work is to be done?
- Is the person provided training to enable them to perform a job in a particular method or manner?
- Are the services provided integrated into the business’ operation?
- Must the services be rendered personally?
- Does the business hire, supervise or pay assistants to help the person performing the services under contract?
- Is the relationship between the individual and the person they perform services for a continuing relationship?
- Who sets the hours of work?
- Is the worker required to devote their full time to the person they perform services for?
- Is the work performed at the place of the business of the potential employer?
- Who directs the order or sequence in which the work must be done?
- Are regular written or oral reports required?
- What is the method of payment – hourly, commission or by the job?
- Are business and/or traveling expenses reimbursed?
- Who furnishes tools and materials used in providing services?
- Does the person providing services have a significant investment in facilities used to perform services?
- Can the person performing the services realize both a profit or a loss?
- Can the person providing services work for a number of firms at the same time?
- Does the person make their services available to the general public?
- Is the person providing services subject to dismissal for reasons other than nonperformance of contract specifications?
- Can the person providing services terminate their relationship without incurring a liability for failure to complete a job?
If you are unclear about how to classify an individual, seek professional guidance before agreeing to pay that person as in independent contractor.
There was a recent Appellate Court case that deal with a satellite TV installer and status as an employee vs. independent contractor. While this was a labor case (dealing with overtime pay), what is important is the analysis that the Court did in reaching its conclusion that the installer was an independent contractor.
Satellite TV installer was independent contractor not entitled to overtime pay
Freund v. Hi-Tech Satellite, Inc., CA11, Dkt. No. 05-14091, 5/31/2006
The Eleventh Circuit Court of Appeals has upheld a district court ruling that a satellite system installer was an independent contractor, rather than an employee, and therefore he was not entitled to overtime pay even though he worked six days each week for one particular company.
Facts. The specific details about how the installer carried out his duties for the satellite company were left to him with the exception that: (1) he was not allowed to perform any additional services that were not paid for by the customers without the satellite company’s approval; (2) he had to wear the satellite company’s shirt during appointments; (3) he had to follow certain minimum specifications for the installations; and (4) he had to call the satellite company to confirm that he had completed the installation and to report any problems that had arisen. The installer was free to perform installations for other companies. Several other installers for the satellite company had created their own corporate entities.
Law. Whether an individual is an employee or independent contractor for purposes of the Fair Labor Standards Act (FLSA) is determined on a case-by-case basis. The U.S. Supreme Court has ruled that certain factors must be taken into account. Those factors are discussed below.
The nature and degree of the alleged employer’s control as to the manner in which the work is to be performed. The district court determined that the satellite company exerted very little control over the installer. Although the satellite company would schedule installation appointments for the installer, the installer could change them. The details of how the installer carried out his duties were generally left to him.
The alleged employee’s opportunity for profit or loss depending upon his managerial skill. The district court noted that the installer was compensated mainly by the job and not by the hour. Therefore, by accepting more jobs, performing more efficiently, and hiring employees, the installer could earn greater sums of money.
The alleged employee’s investment in equipment or materials required for his task, or his employment of workers. The installer drove his own vehicle and provided his own tools and supplies for each installation.
Whether the service rendered requires a special skill. From the record evidence and testimony, the district court discerned that the installer needed special skills to properly install home satellite and entertainment systems.
The degree of permanency and duration of the working relationship. The district court concluded that the installer’s relationship with the satellite company was not one with a significant degree of permanence. It based its conclusion on the fact that the installer was able to take jobs from other installation brokers. The installer could take as many or as few jobs as he desired.
The extent to which the service rendered is an integral part of the alleged employer’s business. In the only factor weighing in the favor of the installer being classified as an employee, the district court found that the installer’s services were an integral part of the satellite company’s business.
Ruling. The Court of Appeals upheld the district court’s ruling that the installer was an independent contractor based on the above analysis. The Court of Appeals said that there was no evidence that the satellite company’s relationship with the installer was any different from its relationship with its other 785 installers, and those installers were treated as independent contractors. The court acknowledged that the installer worked six days a week for the satellite company, but noted that the installer was not required to do so, especially in light of the evidence that some of the other installers worked for the satellite company’s competition at the same time as they worked for the satellite company.
* * * * * * * * * * * *
Here is a discussion of a 2007 case in which the determination of an individual’s status as that of an independent contractor or an employee was discussed at length:
Worker liable for self-employment tax because he wasn’t an employee
Jones v. Commissioner, TC Memo 2007-249, Dkt. No. 18719-05, 8/27/2007
The U.S. Tax Court has ruled that a company was correct in not withholding FICA tax from a worker who was an independent contractor.
Facts. Uriah Jones, a marble and tile installer, worked on a condominium renovation for DBMA Corporation (DBMA) for four months in 2003. DBMA paid Jones $8,360 for his work. At no point did Jones ever sign or submit a Form W-4. In 2003, Jones worked for three other companies that treated him as an employee, and all three companies issued him Forms W-2, rather than Forms 1099-MISC (used for independent contractors). Jones didn’t report the income he received from DBMA on his federal personal income tax return.
Law. Independent contractors pay self-employment tax (SECA) [see IRC §1401 et seq.]. Employees are subject to FICA tax. The overall tax rate is the same, but whereas employers split the FICA tax liability with employees, independent contractors pay the entire SECA. Jones believed he was an employee of DBMA. An employee for purposes of IRC §3121(d) includes a common law employee.
The court looked at the following factors to determine whether Jones was a common law employee: (1) degree of control; (2) investment in facilities; (3) opportunity for profit or loss; (4) the right of the principal to discharge the individual; (5) whether the work performed was an integral part of the principal’s regular business; (6) the permanency of the relationship; and (7) the relationship the parties believed they were creating.
Ruling. The court reviewed the factors above and held that Jones was an independent contractor.
With respect to (1) above, the court said that Jones’ degree of control over his own work on the condominium renovation was consistent with independent contractor status. The court noted that Jones was free to complete the work he was contracted to do by the means and methods of his choice.
With respect to (2) above, the court noted that Jones provided his own tools and most supplies. Additionally, he was not reimbursed by DBMA for the materials that he provided. These facts supported independent contractor status.
With respect to (3) above, the court noted that DBMA paid Jones a fixed sum regardless of the time spent on the job. If Jones underestimated the cost of the supplies needed, or the time it took to complete the job, he bore the risk of losing money, not DBMA. Furthermore, if assistants were needed, it was Jones’ sole responsibility to hire and pay them. Additionally, Jones bore the risk of loss on any loss or damage to his work tools. These facts supported independent contractor status.
With respect to the right to discharge, the court said that the fact that Jones could not be discharged as long as his work met DBMA’s specifications was consistent with independent contractor status.
With respect to (5) above, the court noted that the condominium renovation required tile work, and therefore Jones’ job was an integral part of DBMA’s work. The court believed that the integral nature of Jones’ work could support employee status.
With respect to (6) above, the court noted that once DBMA completed the condominium renovation, the relationship between Jones and DBMA ended. This factor supported independent contractor status.
With respect to (7) above, there was a discrepancy between the parties regarding the relationship they believed that they were creating. Jones thought that an employment relationship was being created as he had always has been treated as an employee by other marble and tile companies. DBMA always treated its workers as independent contractors. The court said that the facts supported independent contractor status as Jones had failed to submit a Form W-4 to DBMA. (He had submitted a Form W-4 to his three other employers.) In addition, there was no indication that Jones had requested or inquired about a Form W-4 from DBMA.
The court noted that only one of the above factors supported employee status.
Lastly, anytime you have an employee working for you, all wages you pay that employee, including bonuses, awards, etc, should be reported on form W-2 and proper taxes withheld. An individual does NOT have a dual-status with their employer. An exception can be for an employee (usually a corporate office) who is a member of a Board of Directors for a Corporation. An individual in that capacity is typically considered to be performing services as a director in a self-employed capacity.
Salesman wasn’t statutory employee; deductions were subject to 2% of AGI floor
Rosemann, TC Memo 2009-185
The Tax Court has held that a salesman didn’t qualify as a statutory employee under Code Sec. 3121(d)(3) and as a result, couldn’t claim business deductions on Schedule C. Rather, he was a common law employee whose out-of-pocket employment related expenses were only deductible on Schedule A, subject to the 2% of adjusted gross income (AGI) floor. The fact that an audit of an earlier tax year permitted him to file as a statutory employee didn’t matter.
To determine adjusted gross income (AGI), income derived from rendering services as a statutory employee described in Code Sec. 3121(d)(3) is income from a trade or business—reportable on Schedule C (Form 1040)—and all allowable deductions attributable to the earning of that income may be taken as a trade or business expense. ( Rev Rul 90-93, 1990-2 CB 33 ) By contrast, a common law employee’s earnings are reported as wages and his out-of-pocket business-related deductions are deducted on Schedule A to the extent they exceed 2% of his AGI.
Under the common law rules (so-called because they originate from court cases rather than from the Code), an individual generally is an employee if the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it. In general, the factors used to determine if an individual is a common law employee are:
(1) The degree of control exercised by the principal;
(2) which party invests in work facilities used by the individual;
(3) the opportunity of the individual for profit or loss;
(4) whether the principal can discharge the individual;
(5) whether the work is part of the principal’s regular business;
(6) the permanency of the relationship;
(7) the relationship the parties believed they were creating; and
(8) the provision of employee benefits.
An individual is a statutory employee under Code Sec. 3121(d)(3) only if he is not a common law employee under Code Sec. 3121(d)(2) , or an officer of a corporation under Code Sec. 3121(d)(1) . Under Code Sec. 3121(d)(3)(D) , one of the statutory employee categories consists of a traveling or city salesman, other than as an agent-driver or commission-driver, engaged on a full-time basis in the solicitation on behalf of, and the transmission to, his principal (except for sideline sales activities on behalf of some other person) of orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments for merchandise for resale or supplies for use in their business operations. The contract of service must provide that substantially all of such services are to be performed personally by the individual. An individual isn’t a traveling or city salesman if he has a substantial investment in facilities used in connection with the performance of such services (other than in facilities for transportation), or if the services are in the nature of a single transaction not part of a continuing relationship with the person for whom the services are performed.
Facts. James Rosemann was an outside salesman for Cooper Container Corp. and received a salary and quarterly commissions for taking orders for cardboard containers and packaging. He worked mainly out of his vehicle and his home. Rosemann was required by Cooper to work 40 hours per week during business hours and to report to its place of business for meetings once or twice a week. He could not wear casual clothes in Cooper’s offices or when calling on customers. Cooper had the right to discharge Rosemann at will and provided him with a $5,000 life insurance policy, 3 weeks of annual paid vacation leave, sick leave, health insurance, a 401(k) retirement plan, and an auto to use for business (as well as some personal) purposes. The Forms W-2, Wage and Tax Statement, which Rosemann received from Cooper did not indicate in box 13 that Rosemann was a statutory employee. Cooper withheld Federal taxes as well as Social Security and Medicare taxes from Rosemann’s wages and commissions.
When IRS audited Rosemann’s ’95 and ’96 returns, the auditor agreed that he was then qualified as a statutory employee, and Rosemann continued using that same status in his income tax returns for later years. On his 2004 and 2005 returns, Rosemann claimed Schedule C deductions of $4,745 and $6,438 respectively. IRS audited those years and determined he was a common law employee rather than a statutory employee, and that his work-related deductions were improperly claimed on Schedule C and should have been claimed on Schedule A as employee business expenses, subject to the 2%-of-AGI floor.
Taxpayer wasn’t a statutory employee. The Tax Court concluded that he was a common law employee under the eight-part test explained above and thus was automatically barred from being a statutory employee. It found that:
… Although Rosemann had some independence and flexibility in planning his sales work and contacting customers in promoting company products, Cooper retained and exercised considerable control over his activities. He was an at-will employee, as were all who worked for Cooper. He was subject to dismissal, had to attend regular weekly meetings at the Cooper facility, had to keep normal business hours (a minimum of 40 hours per week), and had to observe Cooper’s no-jeans dress code. His productivity was periodically checked and Cooper’s officers treated him as an employee.
… Rosemann’s work for Cooper did not involve a risk of financial loss. Cooper invested in facilities (including his business car), not him.
… Rosemann was paid a salary and commissions, with periodic reconciliations and didn’t otherwise have any opportunity for profit or loss while he worked for Cooper.
… Cooper retained the right to discharge Rosemann at will.
… Rosemann’s selling services were an integral part of Cooper’s regular business of manufacturing and selling cardboard shipping containers and packaging.
… Rosemann worked for Cooper since ’92, indicating a significant permanency of the relationship between the two.
… While Rosemann and Cooper had no written employment contract, Cooper retained the right to discharge Rosemann and other controls over his employment, elected not to check the box 13 on Forms W-2 indicating that Rosemann was a statutory employee, withheld income taxes, employment taxes, and Medicare taxes, and provided him with several employee benefits.This tended to show that the nature of the relationship Cooper thought it was creating with Rosemann was that of employer-employee.
… Rosemann received substantial benefits from his employer (e.g., vacation, health insurance, life insurance, sick leave, 401(k) plan).
The Tax Court acknowledged that Rosemann passed muster as a statutory employee when he was audited in the ’90s, but pointed out that each tax year stands alone, with IRS retaining the right to challenge in a succeeding year what was condoned or agreed to in a previous year.