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By Susan Willey

March 06, 2010

Erroneous Worker Classification Creates Tax Liability

In late September 2009, the Boston Globe reported that strippers filed suit against their club employer for allegedly misclassifying them as independent contractors. A Massachusetts state court recently ruled in a class action lawsuit that 70 strippers had been misclassified as independent contractors under state law. Economic pressure motivated these workers to seek employee status as opposed to being considered an independent contractor. It is foreseeable that workers in less controversial professions may also assert their right to be treated as employees, resulting in a significant tax cost to their employers.

Disgruntled workers are more frequently asking the IRS to determine if they are appropriately classified as self-employed workers. Individuals may file Form SS-8 and request the advice of the IRS to learn if their employment classification is correct. The employer may not know that an employee has requested IRS guidance until an auditor appears to question the employer’s classification method.

With a slower economy, many employers are adding workers as independent contractors to limit overtime expense, payroll taxes, workers’ compensation expense, benefit costs and unemployment insurance expense. The governmental entities that assume these employer costs are redoubling their audit efforts. Governmental entities are becoming vigilant in their enforcement of worker classification issues to limit their unemployment cost exposure, workers compensation exposure and medical expense. Governmental entities are also auditing this issue to protect their revenue streams from payroll taxes and income tax withholding.

The IRS has signed information-sharing compacts with the States. The IRS announced at the end of September 2009 that the agency is assigning 200 agents to worker classification issues. The IRS plans to audit 6,000 businesses for worker classification issues in the next year. On a similar track, Iowa’s legislature created a special unit within Iowa Workforce Development to investigate employee misclassification.

The consequences of misclassification for employers are significant. If a worker is erroneously classified as an independent contractor the employer has not withheld income tax, FICA and FUTA. These workers generally lack worker’s compensation coverage and employer-provided fringe benefits.

Often, the IRS assesses the employer for both the employer and the employee’s share of FICA and FUTA. The IRS can assert that an employer’s benefit plans may be a taxable benefit because the plan failed to include recently reclassified employees. Penalties are significant and interest is always assessed.

Wise employers consider the attributes of a job against the IRS guidelines. They document the reasons for their determination. They treat similarly situated workers consistently.

The IRS recently changed the guidelines for determining employee v. independent contractor status. The agency replaced a twenty-factor Common Law test with a test looking to three major categories: the behavioral control test; the financial control test; and the relationship of the parties test.

The behavioral control tests examine the instructions the employer gives the worker and the training the employer provides the worker. The IRS notes that the following employer instructions point to employee status:
- When and where to do the work
- What tools or equipment to use
- What workers to hire to assist with the work
- Where to purchase supplies and services
- What work must be performed by a specified individual, or
- What order or sequence to follow when undertaking the work.

The financial control test attempts to evaluate the amount of control a business may exercise over a worker’s job. Important aspects of financial control demonstrating employee status include:
- The ability of a worker to be reimbursed for expenses
- Limited investment in work materials by the worker other than the worker’s time
- Payments for wages associated with time periods as contrasted with payments by the job, or
- Inability to recognize profit or loss on a job.

The relationship test attempts to evaluate if the relationship is lengthy and more akin to an employer-employee relationship. Pertinent factors in evaluating the employment relationship include:
- Does a written document exist that describes the relationship of the parties?
- Does the business pay the worker benefits analogous to employee benefits?
- Is the relationship long-term?
- Are the worker’s services a key aspect of the employer’s services?

In some ways, the new IRS test resembles the twenty-factor Common Law test rearranged into three groups. The good news is that the tests remain factual. Employers who analyze and document their reasoning for a worker’s classification will have an advantage defending their decisions.