Misclassification of Employees:
Employee vs. Independent Contractor Fact Sheet
Produced by AGA, LLC
The Supreme Court has given no clear definition of what an employer-employee relationship is, under the Fair Labor Standards Act (FLSA). This relationship cannot be defined by one variable or characteristic, rather the whole situation must be considered. The difference between an independent contractor and an employee is a gray area. While there is no distinct definition describing the difference between an independent contractor and an employee, there are multiple tests to help determine the proper classification. Tests that can be used to determine proper classification are Common law 20-factor test, IRS three factor test, overriding federal statutory provisions and the ABC Test.
Common Law Test:
This test was originally developed to evaluate the right of control and can be used to validate the classification.
- Level of instruction: Does the company dictate where, how and when the work is done?
- Amount of training: Is the company providing training?
- Degree of business integration: Is the activity an integral part of the hiring company’s operations?
- Extent of personal services: Who is assigning the work?
- Control of assistants: Who has the control over hiring and paying additional helpers?
- Continuity of relationship: Is there an on-going relationship?
- Flexibility of schedule: Who dictates the work schedule?
- Demands for full-time work: Is there enough work to be equivalent to the definition of a full-time job?
- Need for onsite services: Is the work being performed at the hiring company’s primary location?
- Sequence of work: Does the company have control of the order which work is performed?
- Requirements for reports: Are regular progress reports required?
- Method of payment: Regular pay schedule suggests employee. Independent contractors typically set one price per project.
- Payment of business or travel expenses: Is the worker being reimbursed for business expenses or travel fees?
- Provision of tools and materials: Is the company providing materials and equipment?
- Investment in facilities: Who is providing the work facility?
- Realization of profit and loss: Are there predetermined earnings? Is there the ability to earn a higher profit?
- Work for multiple companies: Is work being performed simultaneously for multiple companies? Is the hiring company the main source of work?
- Availability to public: Is the services provided by the worker available to the public to hire?
- Control over discharge: Does the company have the ability to discharge the worker at any time?
- Right of termination: Can the individual providing the service terminate the work at any time?
IRS Three Factor Test:
This test categorizes the situation into the three various controls in order to determine worker status.
- Behavioral control: Is the company determining how, where and when the work is done?
- Financial control: Who is in control of the economics of the services? Factors which play a significant role in determining financial control are investment, unreimbursed expenses, opportunity for profit and loss, availability of services and method of payment.
- Relationship control: How do the parties view the relationship? These factors include written contracts, benefits, permanency and services provided to the business as a key activity.
While the classification cannot be determined by one variable alone, the whole situation needs to be analyzed on a case by case basis.
Audits by the IRS are often triggered from another audit, typically one from the State Department or the Department of Labor. The DOL will use an economic realities test when determining the classification of the worker.
Economic Realities Test:
This test is comprised of six factors for the determination of classification.
- What is the degree to which the functions of the worker are essential to business operations? Is the employee providing services which are integral to the company’s operations?
- What is the nature of the on-going relationship between the worker and the company? Is there a permanent relationship established?
- How much financially has the worker invested into their own supplies and how does this compare to industry average?
- How much control does the company have over the worker?
- Does the company have an impact on the profit/loss opportunities of the worker?
- What is the level of skill, judgment and initiative needed for the services provided by the worker?
Vermont Department of Labor Classification Standards (ABC Test):
The Vermont Department of Labor considers the term employee to mean workers who are entitled to be covered for unemployment purposes. Employers may be liable for unemployment insurance for the following services:
- Full Time
- Part Time
- Temporary work
- Seasonal work
- Probationary work
- Work performed on and off premises
- Remote workers
Unemployment insurance is required when there is an employer-employee relationship present. Due to case law, the Department of Labor will assume that an employment relationship exists, and unemployment insurance is required, unless the employer is able to prove that all three parts of the State’s ABC Test have been met.
According to the State of Vermont, ALL the requirements of the ABC Test must be met for a worker to be considered an independent contractor rather than an employee.
- Individuals have been and will continue to be free from control or direction over the performance of services, both under contract of service and in fact.
- Service provided is outside the usual course of business and service is performed outside of all places of business of the enterprise. Usual course of business is any activity that the company conducts on a reoccurring basis.
- Individual is engaged in an independently established trade, occupation, profession or business. Individual is established within their occupation or business.
- *Note: For C to be met, individual must have a history of providing similar services to others
Th State feels that the IRS test is less inclusive and therefore chooses to use the ABC Test. Employers should be aware the State of Vermont will follow the ABC Test and may rule a worker an employee although the IRS standards classify the worker as an independent contractor.
While the various tests may use different factors or questions to evaluate the situation, each test analyzes the information in order to establish whether there is an employer-employee relationship present. These factors also indicate whether the classification of the worker is justified. If these tests show a misclassification of an employee, it is in the company’s best interest to reclass the worker properly. Since there are benefits and taxes that are only applicable to employees, many government agencies are quick to class the worker as an employee. When dealing with subcontractor relationships, there should be justifications set into place that could withstand an audit. An agreement between the subcontractor and company is not enough to withstand an audit, nor is common industry practice.
There are workers who are automatically classified as employees. These workers are:
- Corporate officers who perform services for the company.
- Food and Laundry drivers
- Full-time traveling or city salespeople who sell goods to people or firms for re-sale.
- Full time life insurance agents
- Remote workers who are supplied with materials needed for the work to be done.
- State and local government employees. (Those working under the Social Security Act)
There are also workers who are automatically exempt from employee status:
- Direct sellers who sell product to the final user.
- Licensed real estate agents
- Newspaper carriers and distributors
- IRC 3506- Companion sitters
- Corporate officers who provide no services to the company.
Understanding the Penalties:
IRS Form SS-8:
IRS Form SS-8 is filed when an individual is requesting the IRS to determine the status of the worker. The following should be understood by both the employer and the accounting firm after a Form SS-8 has been filed.
- A filed Form SS-8 will likely find the worker to be an employee. This classification is more beneficial to the worker.
- This determination is only applicable to the worker or class of workers who have requested a determination.
- An employer may disregard the letter if they qualify for Section 530 Relief.
- The SS-8 determination process constitutes an official IRS audit.
When an SS-8 is filed, the IRS will investigate and issue a determination unless the situation is hypothetical, the statute of limitations has run out on the time period, and the purpose is for other reasons other than federal tax purposes.
While it is not standard procedure, an SS-8 may cause an examination and give reason to perform an audit.
Section 530 Relief (Safe Harbor):
Section 530 of the Revenue Act of 1978 allows an employer to treat a worker not as an employee for employment tax purposes (not income tax), regardless of the common law test. The taxpayer must have a reasonable basis for this treatment. Under Section 530, reasonable basis for treatment of a worker as a subcontractor is considered to exist if the employer has relied on the following:
- Past IRS Audit practice with respect to the taxpayer
- Published rulings or judicial precedent
- Longstanding recognized practice of the industry.
- Other reasonable basis such as the advice from an attorney or an accountant may also uphold the classification. However, there must be a reason as to why this individual would have knowledge within this area.
- The determination from a state agency may qualify has reasonable basis if they follow the same common law rules and interpretations.
Additional requirements will also need to be satisfied in order to qualify for the Section 530 relief. The employer must not have treated the worker as an employee for any period after 1978. All federal tax returns must have also been filed in a timely manner. The employer cannot have treated a worker with a substantially similar position as an employee for the purposes of employment tax.
Section 530 prohibits the Department of Treasury and IRS from publishing regulations and revenue rulings regarding the employment status of any worker for purposes of employment taxes. However, the employer may request a determination for the purposes of federal employment taxes and income tax withholding.
Section 530 is only available to workers who determine their status through the common law test. In order to be eligible for section 530, the company must meet three requirements.
- The affected workers must have been consistently treated as independent contractors.
- All other workers performing similar tasks must have also been classified as independent contractors.
- All 1099s must have been filed in a timely manner.
Voluntary Classification Settlement Program:
This program provides employers the opportunity to reclassify their workers for employment tax purposes for future tax periods with partial relief from federal employment taxes. In order to participate in this program, the employer must meet eligibility requirements and file an application in order to enter into an agreement with the IRS. In order to be eligible for this program, the following must be met: (Zimbler, 2019).
- Have consistently treated workers as non-employees.
- Have filed all 1099 forms for the workers over the past three years on a timely basis.
- Company cannot be under an IRS audit.
- Company cannot be under a classification audit that is performed by either the IRS, DOL, or State Agency.
When entering this program, companies are agreeing to treat workers within this class of work as employees for all future periods.
The hiring company will be responsible for paying 10% of the employment tax for compensation paid to the worker within the most recent tax year. No interest or penalties will be calculated or collected. This program also saves the company from being subject to an audit.
While this program is beneficial in terms of working with the IRS, states may not accept this one-time payment. States may still impose their own penalties for the misclassification of workers and wages.
Federal Penalties and Ramifications:
While the penalties for worker misclassification can be severe, the ramifications are dependent upon whether the DOL and IRS determine the misclassification to have been unintentional, intentional or fraudulent. If the misclassification was unintentional, then the employer will face penalties based off payments made. If the misclassification is suspected to be intentional or fraudulent, then there are typically additional fines and penalties imposed. Criminal penalties may also be assessed for each misclassified worker and it is possible that a prison sentence could be imposed. In addition, the persons responsible for withholding payroll taxes may be held responsible for uncollected tax.
IRC Section 3509 rates are applicable as a one-time opportunity to correct the treatment of the misclassified employees. The rates under this program are 1.5% of withholding tax and employee FICA is 20% of the statutory rate- which would be 1.53%. The rates however double if the hiring company did not file 1099s.
IRC Section 6205 provides employers the opportunity to correct prior years employment tax returns without interest.
What Employers and Accounting Firms Should Know?
When it comes to misclassification, accounting firms should be working proactively to ensure proper classification is taken place. Subcontractor agreements must be consistent and have relationships which can uphold the various factors.
Legal liability of the Accounting Firm and/or Employer:
The IRC 7501 provides that any person who is required to collect or withhold any internal revenue taxes from any person, pays over the tax to the United States, and who fails to do so, may be held liable under The Trust Fund Recovery Penalty (TFRP), IRC 6672(a).
The TFRP has three primary purposes:
- To encourage payment of income and employment taxes on a timely basis
- Makes the responsible person liable for 100% of the unpaid taxes
- Facilitates collection of taxes from secondary sources.
A person may be held liable under the TFRP for two reasons:
- The person is responsible for the collection and payments over the trust fund taxes to the government
- The person willfully failed to collect or pay taxes to the government.
Persons Subject to the Trust Fund Recovery Penalty:
- Officer or employee of the corporation
- Partner or employee of a partnership
- Member or employee of an LLC
- Corporate director or shareholder
- Another corporation
- Surety or lender
- Payroll Service Provider
- Responsible parties within a payroll service provider
- Professional Employer Organization
- Responsible parties with a professional employer organization
- Responsible parties within the common law employer (Client of PSP/PEO)
The person who will be liable for the funds is not always the one within the corporation. It is determined by who has control over the payments of funds for the business.
The hiring company is 100% liable for all penalties, interest and taxes that were due. The worker is not responsible for the collection of withholding or FICA taxes. If the worker properly paid the taxes due on the amounts which they were paid, the company’s tax bill may be reduced by that amount.
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Internal Revenue Service. (n.d). Information Guide for Employers Filing Form 941 or Form 944.
Internal Revenue Service. (2012). Liability of Third Parties for Unpaid Employment Taxes.
Messina, F, By, B, Polack, L, Messina, M. (2019). Employee Versus Independent Contractor: The IRS and Department of Labor’s Focus on Worker Classification. Retrieved from https://www.cpajournal.com/2019/02/11/employee-versus-independent-contractor/
U.S Department of Labor. (2014). Fact Sheet #13: Am I an Employee? Employment Relationship Under the Fair Labor Standards Act (FLSA).
Vermont Department of Labor. (2019). Who is an Employee vs. Independent Contractor?
Zimbler, L. (2019). Worker Classification Issues: Employee or contractor? TaxPro Journal, 26(3), 9–24.