Independent Contractor or Employee - There Are Tests To Determine What Your Worker Will Be

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By Gerald S. Deutsch, Esq.
Glen Head, NY

Last October, the Court of Appeals for the Sixth Circuit reversed a portion of a Tax Court Memo Decision (2007-66) dealing with whether the classification of workers/truck drivers were employees or independent contractors.

Of course, if a worker is an employee, then both the worker and the employer must pay their share of social security and Medicare taxes and the employer must withhold the employee's share of these taxes as well as income taxes from wages. In addition, if a worker is an employee, the employer may be liable for other employee costs including the worker's inclusion in employee benefit plans. There will also be requirements under Workers Compensation laws. On the other hand, if the worker is an independent contractor he must pay his own self employment taxes and pay estimated income taxes.

Which classification is better? Well, for the employer, generally hiring independent contractors would be less expensive because (i) there would be a savings of payroll tax, employee benefits, worker's compensation etc., and (ii) there would not be the burden of having to withhold. For the worker, as an independent contractor his self employment tax would be greater than his share of social security and Medicare taxes (even with the deduction for these taxes that he is allowed). As an independent contractor, however, the worker would be able to file a “Schedule C” and deduct related business expenses for (rather than from) adjusted gross income (and, if desired, take the standard deduction as well). An employee would be required to deduct such expenses as “Miscellaneous Itemized Deduction” which (i) can be taken only if the standard deduction is not, (ii) is subject to a “floor” of 2% (meaning that these expenses are deductible only to the extent that they exceed 2% of adjusted gross income), and (iii) is not allowed at all for alternative minimum tax purposes.

What makes a worker an employee? Well, in Rev. Rul. 87-41, the IRS has listed 20 factors “under the common law rules for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax at Source on Wages” to determine who are employees. The ruling says that “(t)he twenty factors have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed.”

What happens if an employer erroneously classifies a worker as an independent contractor and the IRS later determines that the proper classification should have been as an employee? Well, there is a statutory provision (Section 530 of the Revenue Act of 1978) that provides that the IRS may not retroactively classify an individual as an employee if certain conditions are met including that the employer had a “reasonable basis” for treating the worker as an independent contractor. Among the factors that can give rise to a “reasonable basis” include, according to Section 530, a judicial precedent.

In a recent case, the U.S. Court of Appeals for the Sixth Circuit (Peno Trucking, Inc. v Comr., 102 AFTR2d 2008-6433 (2008) (unpub. opin.) reversed the Tax Court (T.C. Memo 2007-66). The Tax Court had denied Section 530 relief in not accepting decisions of the Ohio Industrial Commission (OIC) (which found that one of the workers “was not an employee --- on the date of the injury”) and the and the Bureau of Workers Compensation (BWC) (which found “there is no proof of an employee/ employer relationship between the injured worker and the listed employer”). These agencies held that the workers were not eligible for workers compensation from the employer because they were not employees. The employer thought these decisions would constitute judicial precedent sufficient to provide the reasonable basis requirement for the applicability of Section 530.

The Tax Court found that “for a taxpayer to have a reasonable basis for not treating an individual as an employee under the judicial precedent safe harbor, the judicial precedent relied upon must have evaluated the employment relationship through a federal common law analysis.” The Sixth Circuit disagreed and, instead held (citing precedents) that “Congress intended 'that this reasonable basis requirement be construed liberally in favor of taxpayers.’” It found too, that “Congress intended to protect employers who exercised good faith in determining whether their workers were employees or independent contractors.” The court also noted that the Ohio agencies did employ a common law employment test that was similar to the federal test.

Note that this Section 530 relief is available only to employers and not to the workers. If a worker claims that an employer has misclassified an employee as an independent contractor, there is no reasonable basis defense. In addition, it is not available to certain technical personnel (engineer, designer, drafter, computer programmer, system analyst or other similarly skilled worker engaged in a similar line of work) whose services are provided to the employer by another person. Nevertheless, the Peno Trucking case is very favorable to employers by allowing them to reasonably rely on some state agency decisions that will prevent a retroactive reclassification of independent contractors as employees.

For more information, in the Tax Management Portfolios, see Marmoll, 391 T.M., Employment Status -- Employee v. Independent Contractor, and in Tax Practice Series, see ¶5430, Employees and Independent Contractors.