Why do business owners want to have Independent Contractors?
If a business can classify a person performing work for them, what are the advantages to the business owner?
One of the main reasons is a tax savings as they do not have to withhold payroll taxes and do not have to pay the employer match on payroll taxes. Another reason is they do not have to offer the independent contractor health insurance, workmen’s compensation, or 401K plans. Independent contractors are also not covered by minimum wage and hour laws as the business owner does not have to pay downtime or over time to the independent contractor.
Why does the IRS want individuals to be classified as Employees?
The major reason it is easier to collect taxes from an employer for Social Security, Medicare and Federal Income Taxes from a business than collecting Self-Employment Taxes from and independent contractor. Self Employment Taxes are the equivalent of the Social Security and Medicare taxes. Self employed individuals also can reduce the amount of taxes paid with business deductions. Where employees pay and withhold Social Security, Medicare and Income taxes based on their gross salaries.
What are the rules that determine whether and individual is an Employee or an Independent Contractor?
A worker who is required to follow the instructions of another person about how, when, and where the work is to be done is ordinarily an employee. The control factor is present; if the person for whom the services are being performed has the right to set required compliance with instructions for the person performing the services.
Requiring the worker to be trained by an more experienced employee, requiring them to attend meetings, or by using other methods of training to perform the work using a particular manner indicates that this person should be classified as an ordinary employee.
It is when the integration of the workers services into the business’s operations and the worker is subject to direction and control of the business. When the success or continuation of the business depends to an appreciable degree upon the performance of certain services the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business.
4. Services Rendered Personally:
If the services must be rendered personally, presumably by the person or persons for who the services are performed are interested in the methods used to accomplish the work as well as in the results.
5. Hiring, Supervising, and Paying Assistants:
If the business owner or owners for whom the services are performed hire, supervise, and pay assistants, that fact generally shows control over the workers on the job. However, if one of the workers hires, supervises, and pays the other assistants in performance of a contact under which the worker agrees to provide materials and labor, and under which the worker is responsible only for the attainment of a result, this fact indicates this worker to be classified as an independent contractor.
6. Continuing Relationship:
A continuing relationship between the worker and the business owner(s) for whom the work is performed indicates that and employer-employee relationship exist. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.
7. Set Hours of Work:
The setting of specific work hours by the business owner(s) for whom the work is performed is a factor in indicating control.
8. Full time required:
If the worker must devote full time to the business of the business owner(s) for whom the services are performed then the business owner(s) have control over the amount of time the worker spends working and restricts the worker from doing other gainful work. An independent contractor on the other hand is free to work when and for whom they choose.
9. Doing work on the business owner(s) premises:
If the work performed on the premises of the business owner(s) for whom the work is performed, that suggests control over the worker, especially if the work could be done elsewhere.
Rev. Rul. 56-660, 1956-2 C.B. 693. Work done off the premises of the business owner(s) receiving the services, such as at the office of the worker, indicates some freedom from control. However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer’s premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required.
10. Order or sequence set:
If a worker must perform services in the order or sequence set by the business owner(s) for whom the services are performed, then that is a factor that shows the worker is not free to follow the worker’s own pattern of work, but must follow the established routines and schedules of the business owner(s) for whom the services are performed. Sometime because of the nature of the occupation, the business owner(s) for whom the services do not set the order of the service or set the order infrequently. It is sufficient to indicate control if the business owner(s) retain the right to do so.
11. Oral or written reports:
A requirement that the worker submit regular or written reports to the business owner(s) for whom the services are performed indicates a degree of control.
12. Payment by the hour, week, month:
Payment by the hour, week, or month generally points to an employer-employee relationship, provide that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on straight commission generally indicates that the worker is an independent contractor.
13. Payment of business and/or traveling expenses:
If the business owner(s) for whom the services are preformed ordinarily pay the worker’s business and –or traveling expenses, those worker(s) is ordinarily an employee. If the employer is able to control expenses generally retains the right to regulate and direct the worker’s business activities.
14. Furnishing of tools and materials:
If the business owner(s) for whom the services are performed furnish significant tolls, materials and other equipment tends to show the existence of an employer-employee relationship.
15. Significant investment:
If the worker invest in facilities that are used by the worker in performing services and are not typically maintained by the employees (such as the maintenance of an office rented at fair value from and unrelated party) this tend to indicate that the worker is an independent contractor. However, the lack of investment in facilities indicates a dependence on the business owner(s) for whom the services are being performed for such facilities and indicate the existence of an employer-employee relationship.
16. Realization of Profit or Loss:
A worker who can realize a profit or suffer a loss as the result of the workers services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor.
Rul. 70-309. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.
17. Working for more than one business at a time:
If the worker performs more than the minims services for a multiple of unrelated businesses at the same time that would generally indicate the worker is an independent contractor.
Rev. Rul. 70-572, 1970-2 C.B. 221. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.
18. Making services available to the general Public:
If a worker that makes their service available to the general public on a regular and consistent basis indicates an independent contractor relationship.
19. Right to work discharge
The right to discharge a worker can indicate that the worker is an employee and the business owner(s) possessing the right is an employer.
If an employer exercises control through the threat of dismissal, cause the worker to obey the employers instructions. An independent contractor cannot be fired so long as the independent contractor produces results that meet the contract specifications.
20. Right to terminate:
If the worker has the right to end their relationship with the business owner(s) for whom the services are performed at any time they wish without incurring, liability, that factor indicates and employer-employee relationship.
What happens if individuals are classified incorrectly?
The IRS has the right to audit 3 years and the consequences for misclassifying and individual can be over 10% (of compensation paid) in tax for 3 years plus penalties and interest. This could put smaller business in the hole they can never climb out of.
Be sure to always file form 1099 to be eligible for any of the three relief methods available.
Section 530 refers to section 530 of the Revenue Act of 1978.
Section 530 provides businesses with relief from federal employment tax obligations if certain conditions are met. Businesses may be relieved of their obligations both retroactively and prospectively if these conditions are met.
Section 530 was originally enacted as a response to taxpayer complaints that the IRS was too aggressive with respect to worker reclassification issues.
In its training materials the IRS states that Section 530 is a relief provision that should be considered as the first step in any case involving worker reclassification.
Section 530 allows businesses to treat workers as independent contractors if they meet the following conditions:
• Complied with the Form 1099 reporting requirements with respect to compensation paid the workers (reporting consistency)
• Consistently treated the workers (and similarly situated workers) as independent contractors (substantive consistency)
• Had a reasonable basis for treating the workers as independent contractors
The classification settlement program establishes procedures for settlement in cases where a taxpayer does not qualify for section 530 relief.
Generally the situations in question would be where a taxpayer meets the reporting consistency requirement and only one of the two remaining requirements (substantive consistency and reasonable basis).
Under the classification settlement program, the taxpayer will have to agree to treat the workers as employees on a prospective basis.
The IRS also has a program in which businesses can voluntarily reclassify individuals formerly classified as independent contractors as employees in the future for a fraction of the penalty that would be paid if caught.
HOW TO GUARD AGAINST RECLASSIFICATION
Business owners make sure you meet the requirements of section 530 relief for reporting consistency (making sure Forms 1099 are filed timely), substantive consistency and reasonable basis.
Business owner(s) do sign contracts with independent contractors that specifically state they will be treated as independent contractors. These contracts would ideally have ending dates as opposed to being open ended.
Do not allow independent contractors to participate in any employee benefit packages.
Have independent contractors carry their own workman’s compensation policies.
Do not give independent contractors employee manuals or instructions so detailed as to show control by the business.
Have the independent contractor submit bills for services rendered. Include in the independent contractor’s file any advertisements and business cards or anything else showing that they are holding themselves out as independent contractors.
Here is the link to the IRS website to gain further information: