Henricks, Martin, Thomas & Zollars, Ltd.
Certified Public Accountants

The article below was written by Ed Zollars, CPA, and a previous version has been included as part of the Frequently Asked Questions list for misc.taxes.moderated. The article was originally written from the perspective of the person who would be classified as an employee or independent contractor, but the issues involved are similar from the employer's perspective

As is noted, this issue involves professional judgment as to the weighting of various criteria. If you wish to engage us to consult with you on these issues, please contact us. We can be reached via the phone numbers listed above or, if you prefer, via email at hmtzcpas@getnet.com.

Employee Status Questions

The following is for general information only. It is not intended to be tax advice and should not be relied upon. Please contact your tax advisor for specific questions.

Q) I have been hired by an entity to perform certain services. How can it be determined whether I am an employee or an independent contractor for tax purposes?

The issue of classifying individuals as employees or independent contractors has been addressed by the IRS in Revenue Ruling 87-41. That ruling provides 20 tests to be considered in determining if an individual is an independent contractor or an employee. An excerpt from that ruling is reproduced below:

begin quoted material (Rev. Rul. 87-41)

1. INSTRUCTIONS. A worker who is required to comply with other persons' instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions. See, for example, Rev. Rul. 68-598, 1968-2 C.B. 464, and Rev. Rul. 66-381, 1966-2 C.B. 449.

2. TRAINING. Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner. See Rev. Rul. 70-630, 1970-2 C.B. 229.

3. INTEGRATION. Integration of the worker's services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a 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. See United States v. Silk, 331 U.S. 704 1947), 1947-2 C.B. 167.

4. SERVICES RENDERED PERSONALLY. If the Services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results. See Rev. Rul. 55-695, 1955-2 C.B. 410.

5. HIRING, SUPERVISING, AND PAYING ASSISTANTS. If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract 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 factor indicates an independent contractor status. Compare Rev. Rul. 63-115, 1963-1 C.B. 178, with Rev. Rul. 55-593 1955-2 C.B. 610.

6. CONTINUING RELATIONSHIP. A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals. See United States v. Silk.

7. SET HOURS OF WORK. The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control. See Rev. Rul. 73-591, 1973-2 C.B. 337.

8. FULL TIME REQUIRED. If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work. An independent contract or on the other hand, is free to work when and for whom he or she chooses. See Rev. Rul. 56-694, 1956-2 C.B. 694.

9. DOING WORK ON EMPLOYER'S PREMISES. If the work is performed on the premises of the person or persons for whom the services are performed, that factor 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 person or persons 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 canvas a territory within a certain time, or to work at specific places as required. See Rev. Rul. 56-694.

10. ORDER OR SEQUENCE SET. If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker's own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if such person or persons retain the right to do so. See Rev. Rul. 56-694.

11. ORAL OR WRITTEN REPORTS. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control. See Rev. Rul. 70-309, 1970-1 C.B. 199, and Rev. Rul. 68-248, 1968-1 C.B. 431.

12. PAYMENT BY HOUR, WEEK, MONTH. Payment by the hour, week, or month generally points to an employer-employee relationship, provided 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 s straight commission generally indicates that the worker is an independent contractor. See Rev. Rul. 74-389, 1974-2 C.B. 330.

13. PAYMENT OF BUSINESS AND/OR TRAVELING EXPENSES. If the person or persons for whom the services are performed ordinarily pay the worker's business and/or traveling expenses, the worker is ordinarily an employee. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker's business activities. See Rev. Rul. 55-144, 1955-1 C.B. 483.

14. FURNISHING OF TOOLS AND MATERIALS. The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship. See Rev. Rul. 71-524, 1971-2 C.B. 346.

15. SIGNIFICANT INVESTMENT. If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer-employee relationship. See Rev. Rul. 71-524. Special scrutiny is required with respect to certain types of facilities, such as home offices.

16. REALIZATION OF PROFIT OR LOSS. A worker who can realize a profit or suffer a loss as a result of the worker's services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. See Rev. 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 FIRM AT A TIME. If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. See 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 SERVICE AVAILABLE TO GENERAL PUBLIC. The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship. See Rev. Rul. 56-660.

19. RIGHT TO DISCHARGE. The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer's instructions. An independent contractor, on the other hand, cannot be fired so long as the independent contractor produces a result that meets the contract specifications. Rev. Rul. 75-41, 1975-1 C.B. 323.

20. RIGHT TO TERMINATE. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship. See Rev. Rul. 70-309.

end quoted material (Rev. Rul. 87-41)

You or the person hiring you can request that the IRS rule on whether you are an employee or an independent contractor. This is done by filing IRS Form SS-8. Note that if this report is filed by the individual who will be classified, he or she must give consent for his or her name to be disclosed to the potential employer once the IRS has made a determination.

Technical specialists (which includes computer programmers, engineers, draftsmen, and other "similar" occupations) are subjected to tougher scrutiny than other employees. A special exception exists (Section 530 of the Tax Reform Act of 1978) that allows for treatment of certain individuals as independent contractors in situations where this would not otherwise be allowed. In the late 1980's this provision was amended by Congress to specifically exclude individuals in the fields mentioned above.

Q) What difference does it make if I am employee or independent contractor?

An employee's income is reported on a W-2. An employee has withheld from his or her paycheck the employee's share of FICA, along with federal and state taxes. Any deductible expenses incurred by the employee related to the performance of his/her job are only deductible if the employee itemizes by reporting the expenses on Form 2106. Additionally, those expenses are miscellaneous itemized deductions subject to limitation based on adjusted gross income.

An independent contractor has no taxes withheld from the amounts paid to him or her (except for unique situations involving backup withholding). Income from independent contracting is reported on Schedule C of Form 1040, with deductible expenses related to the business reported on that Form and reducing the income. The net income reported on Schedule C is then reported on the front page of Form 1040 and is used on Schedule SE to compute a self-employment tax. The self-employment tax represents both the employer and employee share of FICA taxes.

Self-employed individuals are also able to fund a retirement plan based on the earnings. Self-employed individuals are also allowed to take a deduction for a portion of medical insurance premiums in computing adjusted gross income in certain cases.

Q) What can happen to an employer that misclassifies workers as independent contractors?

Federal tax laws provide for a number of potential sanctions against employers who treat individuals as independent contractors when it is later determined they should have been employees. In the worst case, the employer would be liable for all taxes not withheld (including the federal income taxes not withheld), along with all employment taxes and interest and penalties on the amounts not paid in a timely fashion.

More generally, though, the employer is sanctioned under Section 3509 as long as the failure is not due to intentional disregard of the requirements to withhold the tax. The employer is still responsible for all payroll taxes imposed on the 'employer' in full, but the amount to be paid for failing to withhold taxes from the employee's paycheck is reduced. Generally, the employer is assessed 1.5% of the wages paid as a penalty for failing to withhold federal income taxes and 20% of what should have been withheld as employee FICA for failing to withhold that amount.

The Section 3509 penalties double if the employer did not file 1099's that may have required had the employee been determined to be an independent contractor.

Recent law changes have increased the level of protection to employers under the "Section 530" exception discussed above. However, that section still does not apply to technical employees and the basic rules haven't changed. The law change in 1996 simply defined more liberal terms to apply the exception than the IRS had been applying to the law.

The employer may face additional penalties from other sources, such as state taxing authorities (for state income tax withheld, state unemployment taxes, etc.) and workers' compensation insurance carriers. It is also important to remember that even if Section 530 keeps the employer out of hot water with the IRS, the state agencies may not be bound.

Also, the IRS has taken the position that Section 530 applies only to payroll taxes. If the employer didn't cover someone who is found to be an employee under their employee benefit plan, they may face problems there as well.

Q) I've considered the tests noted above and have decided that I am not an employee. However, my client still says I have to be on the payroll. What can I do?

This is a practical issue. You always could attempt to get an agreement from the client to file an SS-8 and abide by that ruling. However, you have to realize that the IRS has a very real bias towards finding that you are an employee if there is any doubt about the issue. You may also find that certain clients will cite "company policy" on this issue and won't consider any alternative.

At that point it becomes an issue of whether the job is worth enough to give up independent contractor status or whether you should look elsewhere for work.

Q) Will incorporating my practice automatically qualify me as not being an employee?

Not automatically, though the degree of protection this provides is subject to some discussion in the courts. You are likely in trouble if it appears the sole reason you have incorporated is to dodge the employment issue. However, the courts have issued somewhat divided guidance in cases where it's not so clear. This is a case where you likely need to consult with competent counsel before proceeding.

Based upon experiences of others reporting on usenet, it certainly appears that incorporating can calm the nerves of an otherwise skittish client who wants to treat an individual as employee to "be safe".

Q) I've been told that by forming an S Corporation I can avoid paying FICA and other payroll taxes on what I receive as income. Is this correct?

In a limited sense only. First the theory of how an S corporation escapes self-employment or FICA taxes. Earnings from an S corporation are passed out to the shareholders on Schedule K-1 and reported on their individual returns. The earnings are not considered self-employment income and are not subject to self-employment tax. The S corporation is allowed to make distributions of its income to the shareholders with no additional tax effect, subject to certain restrictions. Those attempting to evade payroll taxes use these features of S corporations to attempt to get money for their services without having to pay the payroll taxes.

The IRS has been successful in reclassifying S corporation income as being disguised salary in the case of an accountant. The accountant in question formed an S corporation. He performed virtually all the services required of the corporation, but took no salary at all. He took distributions from the corporation on a regular basis. The court found that the payments were a "disguised" salary since the payments were essentially for the accountant's services. (Spicer Accounting v. U.S.) A similar result occurred when an attorney attempted the same thing. (Radtke v. U.S.) Both taxpayers lost their cases and their appeals to the relevant Circuit Courts of Appeal.

Based on these factors, it appears that anyone forming an S corporation will need to take a "reasonable" salary from the corporation and pay at least some payroll taxes. The issue is one of "facts and circumstances" and doesn't lend itself towards a simple set of rules that can be used to determine what the proper salary is.