Independent Contractors – Regulations – Prevent An IRS Challenge
For years, the IRS has skirmished with small businesses over whether workers should be considered independent contractors or employees. Although numerous legislative fixes have been introduced in Congress, none have passed.
Against this stalemate, here’s what you need to know to protect your business against IRS arguments that your independent contractors should be reclassified as employees.
First, the basics:
Businesses like to categorize workers as independent contractors because it’s easier and cheaper. Generally, when a worker is a “common law employee,” you must withhold federal income tax and the employees half of the Social Security and Medicare (FICA). You almost must pay the employer’s half of the FICA and the federal unemployment tax (FUTA). Finally, a W-2 form must be issued to the employee with copies sent to the IRS.
In contrast, when a worker is an independent contractor, your business can ignore all this. You also don’t have to provide expensive fringe benefits such as health insurance, retirement plans, paid vacations or stock options.
If you pay an independent contractor $600 or more in a calendar year, you must issue the worker a Form 1099-MISC and file copies with the IRS. That’s it.
But big problems arise if you treat a common law employee as an independent contractor without having a “reasonable basis” for doing so. Your company could owe big bucks for back federal payroll taxes, interest and penalties. The cost has driven some businesses into bankruptcy.
Obviously professionals, such as lawyers and architects, who render occasional services to your business and also offer their skills to the general public, are independent contractors. The same is true for plumbers and construction contractors. The same is true for plumbers and construction contractors. Unfortunately, once you get past these easy-to-classify situations, things aren’t so simple.
Here’s the rule of thumb: Workers are independent contractors if they have no control over the way they get the job done. On the flip side, the worker is not independent if you have the legal right to control how he performs his services.
In other words, if that right exists, if doesn’t matter whether or not you actually exercise it. It makes no difference what you call the worker or whether the person works full time or part time. Nor does it matter what is stipulated in a contract. Only the actual “facts and circumstances” count.
You may think that if you simply tell the worker what the job entails then pay based on whether the task is properly completed, you have an independent contractor on your hands. But the issue isn’t quite that straightforward.
The person could still be an employee if he works full time for your company, has no other significant clients and gets paid by the hour, day, week, or month rather than by the job. To do a complete job of assessing a workers standing, you must answer the IRS’ notorious 20 questions. (See box below.)
Strategy: Always have a written contract with the worker to help resolve ambiguous situations in your favor. Clarify important points verbally that may not have been specifically discussed.
The existence of a written contract has helped many companies win their cases in court. In an internal IRS training manual, auditors are asked to check contracts for details of the relationship, such as the method of payment and how the work is to be performed.
However, don’t hurt yourself with a contract that, for example, says the worker must be available 40 hours a week and cannot provide services to other clients while working for you. Also, once you draft a contract that legitimately treats workers as independent contractors, make sure you live up to it. Resist the urge to supervise free-lancers in the same way you oversee your employees.
Note: If your company uses “leased employees,” rather than independent contractors, you generally avoid any problems with reclassification. The service corporation that provides the workers to your firm is considered the employer for tax and fringe benefit purposes.
Let’s assume you duly consider the 20 questions and decide a worker is common law employee. All is not necessarily lost. Under a special statutory exception called “Section 530 relief,” independent contractor status is still permitted if your company can show a “reasonable basis” for putting the worker in that category.
Under current law, when the IRS raises the independent contractor issue, it must supply you with information about the availability off Section 530. There are different ways to pass the “reasonable basis” test. You only need one to get you off the hook.
- Show that independent contractor treatment for the worker is a long-standing, recognized practice in a significant segment of your industry. The IRS admits that “long-standing” can mean less than 10 years, and “significant segment” can mean less than 25 percent. Conduct a survey of similar businesses to make your case in advance. (RR 3/15/99)
- Prove that a prior IRS audit at your business (done after 1996) allowed your handling of similar workers. Of course, for this to apply, you must still be treating the same classes of workers in the same manner.
- Find a court decision or IRS ruling involving a worker in a similar position to support your argument.
- Prove you relied on a professional adviser who was given relevant information. Hire a tax pro to help make your case and then keep written memos or conclusions with your payroll tax records.
If you clear any of these hurdles, you can treat workers as independent contractors, even if they meet the definition of common law employees. This is definitely a loophole left open by Congress.
But take note: We’ve heard that some IRS agents go against the rules by not informing businesses that Section 530 relief is available. (RR 9/29/97) Know your rights and stick to your guns. The IRS must prove your stand is not reasonable if it’s based on any one of the first three items listed at left. (If you rely on the fourth, the burden is on you to prove you’re correct.)
Advisory: It’s crucial that your company file all required IRS paperwork for independent contractors. If you don’t, you can lose the Section 530 relief.
The key point: You must prove that you treated these and similar workers consistently as independent contractors.
Specifically, your prior-year federal payroll tax returns (Forms 940 and 941) should not show the workers as “employees” with federal payroll taxes withheld from their paychecks. You must issue 1099 forms to the workers rather than w-2 forms. In other words, you must practice what you preach.