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There is a common question of whether people providing services to your business are employees or independent contractors. Why does it matter? The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is complex. It is predicated on facts and circumstances and the penalties for incorrect reporting can be severe.

Establishing the employment status of workers is vitally important as the result dictates whether a service recipient will have to withhold employment and income taxes on behalf of the service provider in addition to additional administrative reporting obligations. Establishing such status also has important implications as to whether or not that person is subject to employee retirement, health, and fringe benefit plans, as well as federal, state, and local labor, insurance and employment laws.

For federal tax purposes, a worker is classified as either an “employee” or an “independent contractor.” A worker is considered to be an employee if he or she is one of the following: (1) a common-law employee; (2) a corporate officer; or (3) a statutory employee, e.g., agent-driver or commission-driver, full-time life insurance salesperson, home worker, or traveling salesperson (payor is required to withhold social security taxes on behalf of the payee); or (4) certain state and local government employees covered by an agreement under §218 of the Social Security Act.

The common law rules for determining whether a worker is an employee or independent contractor are described in IRS regulations. Generally, an employer-employee relationship exists when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so. In contrast, individuals such as physicians, lawyers, dentists, contractors, and subcontractors, who follow an independent trade, business, or profession in which they offer their services to the public, generally are not employees.

Some categories of individuals are subject to special rules because of their occupations or identities. For example, corporate directors aren't employees of a corporation in their capacity as directors, and partners of an enterprise organized as a partnership are treated as self-employed persons.

Under certain circumstances, you can ask the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee.

Misclassified Employees in the past?

Some employers that have misclassified workers as independent contractors may be relieved from employment tax liabilities if the employer: filed all federal returns consistent with its treatment of a worker as an independent contractor; treated all similarly situated workers as independent contractors; and had a “reasonable basis” for not treating the worker as an employee. For example, a “reasonable basis” exists if a significant segment of the employer's industry has traditionally treated similar workers as independent contractors.

The IRS recently launched the Voluntary Classification Settlement Program (VCSP). This program allows employers to reclassify as employees those workers they have erroneously treated as independent contractors. The program has generous payment terms, and participants get relief from employment tax audits for previous years.

The VCSP will allow employers to resolve past worker classification issues by voluntarily reclassifying their workers without undergoing an audit.

Who is eligible?

The VCSP is available to taxpayers who have consistently treated their workers (or a class or group of their workers) as independent contractors and now want to treat them as employees prospectively. To be eligible, the taxpayer must have filed all required Forms 1099 for the workers for the previous three years.

A taxpayer who is currently under IRS audit isn't eligible for the program. Likewise, a taxpayer who is under an employment tax audit by the Department of Labor (DOL) or a state government agency is ineligible. However, a taxpayer that was previously audited by IRS or the DOL about the classification of its workers will be eligible if it has complied with the results of that audit.

If you'd like to discuss how these complex rules apply to your business to make sure that none of your workers are misclassified or if you need assistance with preparing the related Form 1099's, please do not hesitate to call our office.