Employee or Independent Contractor? Two Tax Court Cases

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Does your firm use outside workers for some jobs?  This can result in significant tax breaks if the workers are properly classified as independent contractors rather than employees.

Key point: If a worker is an employee, your company must withhold federal income tax and employment taxes from his or her wages.  In addition, your business is responsible for paying the employer’s share of federal payroll taxes.  Conversely, if a worker is characterized as an independent contractor, your company isn’t liable for these payroll tax obligations.

In addition, employers aren’t required to offer independent contractors the same fringe benefits that regular employees receive, which can result in extra savings.

However, it’s not always easy to distinguish independent contractors from employees.  There are several factors the IRS and courts examine but it often boils down to a “control” issue.  If you control how, where and when the worker does the job, he or she is usually classified as an employee.

Here are two cases heard in U.S. Tax Court that illustrate some of the traps that taxpayers can fall into on the employee-versus-independent-contractor issue:

Case #1: Tax Court Disregards Contracts

An Ohio trucking firm had written contracts with drivers to operate as independent contractors.  The company filed 1099 Forms with the IRS for each of the drivers working under the contract.  Nonetheless, the corporation:

  • Hired drivers, oversaw all work performed by them and confirmed the work had been completed.
  • Directed, supervised, paid, disciplined, and discharged the drivers.
  • Decided which days that drivers would work and which loads they carried.
  • Determined when repairs to the trucks were necessary and was responsible for truck maintenance.  The drivers had no investment in the trucks.

Based on these facts, the Tax Court ruled that the drivers should be treated as employees, despite the existence of the written contracts, because the company exerted significant control over their activities. (Peno Trucking, Inc., TC Memo 2007-66)

Footnote: The trucking firm argued that it should be entitled to “Section 530 relief” based on its consistent treatment of workers as independent contractors and the fact that two prior Workers’ Compensation requests by drivers were denied by the state due to their written contracts. (See right-hand box for an explanation of Section 530 relief).  But the Tax Court stated that the Workers’ Comp cases did not evaluate the employment relationships “through a common law analysis.”

Case #2: Are Workers Liable for Taxes if an Employer Wrongly Classifies Them?

What happens if an employer misclassifies a worker as an independent contractor and doesn’t withhold income taxes or FICA? Does that mean the person is not liable for the taxes?  One Florida woman found out the hard way that the answer is “no.”

She worked as a seamstress at a retail bridal gown shop.  The shop classified the woman as an independent contractor and paid her $11,210 during the year in question.  The shop did not withhold income or employment taxes from its payments to her.  The seamstress also received unemployment compensation of $208 that year from the Florida Agency for Workforce Innovation.

The woman failed to file a tax return for the year.  So the IRS filed one for her as a self-employed person with its “Substitute for Return Program” and sent her a tax bill.  Later, the IRS agreed that the seamstress was an employee, rather than an independent contractor.  She contended that the bridal shop, which failed to withhold taxes from her wages, was solely liable for the tax bill.

The Tax Court stated that it was “unfortunate” the employer classified the seamstress as an independent contractor and not as an employee.

But, the court added, “that does not alter the fact that the first principle of income taxation is that income must be taxed to (the person) who earns its” and “misclassification of an employee does not relieve the employee of his liability for filing a correct tax return.” (Natalia Ravelo Escandon, TC Memo 2007-128)

These two cases are two in a long list of court filings against companies that hire independent contractors.  In some cases, workers sue for benefits they claim they were eligible for, including health insurance and retirement plan contributions.

To make matters worse, the IRS continues cracking down on companies that hire independent contractors.  If the tax agency “reclassifies” a worker as an employee, your company could be slapped with hefty bills for back taxes, interest and penalties.  Audits by state agencies are also common and frequently occur when independent contractors apply for unemployment or Workers’ Compensation.

Unfortunately, no single factor determines a worker’s status.  In the trucking company case described above, the Tax Court looked at these seven questions:

1. What degree of control is exercised by the business? Under this test, the court examined how much control the company exerted over the way the services were performed.  But exercising control is not required in an employer-employee relationship, the Tax Court noted, as long as the company has the right to direct a worker if necessary.

2. Which party invests in “work facilities,” used by the individual? “The fact that a worker provides his or her own tools generally indicates a non-employee status,” the Tax Court explained.

3. Does the individual take any financial risk? “A worker’s opportunity to earn a profit and assume risk of loss may indicate a non-employee status,” the Court said.

4. Can the business discharge the individual? “Generally, an employer’s right to discharge an employee indicates an employer-employee relationship,” the Tax Court noted.

5. Is the work an integral part of the company’s regular business? An employer-employee relationship is supported when workers perform a service essential to the success of a business operation.

6. How permanent is the relationship? The Tax Court stated that “a transitory work relationship may point toward a non-employee status.”

7. What kind of relationship do the parties believe they are creating? Entering into a written agreement that states a worker is an independent contractor indicates a non-employee relationship.  However, a contract is not enough.  “If an employer-employee relationship exists, characterization by the parties as some other relationship is immaterial,” according to the Tax Court.

Section 530 of the Revenue Act of 1978

Under Section 530 of the Revenue Act of 1978, an employer can claim independent contractor status for misclassified workers and not owe employment taxes if it can show:

  • There is a “reasonable basis” for the classification
  • The business consistently treated workers as contractors

Here are the ways to qualify for Section 530 relief:

  1. The classification is a long-standing practice of a significant segment of the industry or profession.
  2. The employer was audited regarding the employment tax treatment of workers and the classification was allowed to stand.
  3. The employer relies on an authoritative court decision or IRS ruling to support its position.
  4. The employer based the determination on the sound reasoning of a paid tax professional.

UPDATE: The Department of Labor has released a memo providing employer guidance for determining whether a worker should be classified as an employee or independent contractor.  Click here for our more recent post. 

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