August 21, 2009
Employer Tax Obligations:
Distinguishing Between Independent Contractors and Employees
Businesses often find it difficult to determine whether or not they have withholding obligations with respect to payments made to individuals who performing services or work for the business: is the person performing services an employee -- and thus subject to mandatory withholding, or is the person an independent contractor and outside the mandatory withholding requirements? The consequences are significant because the Internal Revenue Service ("IRS") can hold an employer liable for the amounts not properly withheld. Unfortunately, distinguishing between the two categories of workers can be difficult, as there is no bright line rule. Fortunately, there are some guiding principles and criteria that can be used to make appropriate decisions.
The general rule for distinguishing between employees and independent contractors in the workplace is set forth in Treasury Regulation Section 31.3401(c)-1, and is further supplemented by a set of twenty criteria discussed and applied in IRS Revenue Ruling 87-41, 1987-23 I.R.B. 7). The primary inquiry, set forth in the regulation, is whether or not the employer has the ability to control the individual performing the work, not only with respect to the expected result but also with respect to the means and manner in which the result is to be achieved. If the answer is yes, then an employer-employee relationship exists. The criteria enumerated in Revenue Ruling 87-41 are geared towards answering this key question. As the IRS itself notes, these criteria are guidelines for ascertaining whether an employment or independent contractor relationship exists; no one factor is determinative and "special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement." Rev. Rul. 87-41 at 11. Additional guidance can be garnered from the specific IRS rulings addressing the distinction between employees and independent contractors in the context of specific professions and types of employment -- from accountants to stenographers to vacuum cleaner dealers. The IRS also provides guidance through its publication "Employer's Supplemental Tax Guide", Publications 15 and 15-A, 2009 ("IRS Employer Tax Guides"), which are available for download from the IRS website: http://www.irs.gov/businesses/small/article/0,,id=98868,00.html.
The general rule as set forth in Treasury Regulation Section 31.3401-(c)-1 states, somewhat obviously, that "the term 'employee' includes every individual performing service if the relationship between him and the person for whom he performs such services is the legal relationship of employer and employee." Treas. Reg. § 31.3401-(c)-1(a). Subsection (b) of this regulation further elaborates, as follows:
Generally the relationship of employer and employee exists when the person for whom 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. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so. The right to discharge is also an important factor indicating that the person possessing that right is an employer. Other factors characteristic of any employer, but not necessarily present in every case, are the furnishing of tools and the furnishing of a place to work to the individual who performs the services. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, he is not any employee.
Treas. Reg. § 31.3401(c)-1(b). The regulation also expressly states that any given relationship can only be determined by an examination of the particular facts at hand, and the description of the relationship by the parties themselves is immaterial. Treas. Reg. § 31.3401(c)-1(d)-(e). Further, all classes or grades of employees (e.g., managers and other supervisory personnel) are included within the definition of "employee." Treas. Reg. § 31.3401(c)-1(f). Corporate officers are also specifically included. Treas. Reg. § 31.3401-(c)-1( ). Workers who are generally excluded include those who typically hold themselves out to the public -- e.g., accountants, lawyers, dentists, contractors and others who follow an independent trade or business. Treas. Reg. § 31.3401(c)-1(c).
As noted above, the IRS, in Revenue Ruling 87-41, articulated a set of twenty criteria to assist employees and employees in correctly classifying a given relationship. These twenty criteria are as follows, in full:
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, 91 L. Ed. 1757.
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 contractor, 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 canvass 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 a 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.
Rev. Rul. 87-41 (some internal citations omitted). These criteria are clearly aimed at discerning the degree of a payor's behavioral and financial control over a particular worker, as well as the overall depth of the relationship.
In addition to the criteria enumerated above, another mechanism for alleviating uncertainty in distinguishing between employees and independent contractors is the Section 5430 "safe harbor" rule. See Section 530 of the Revenue Act of 1978, P.L. 95-600, as amended ("Revenue Act"). Under this rule, an individual will not be reclassified as an employee for employment tax purposes providing the taxpayer (i.e., the payor) meets the following requirements:
1. The taxpayer did not treat the worker as an employee for any period;
2. All federal tax returns required to be filed by the worker are filed on a basis consistent with the worker not being an employee;
3. The taxpayer did not treat any worker holding a substantially similar position as an employee; and
4. The taxpayer had a reasonable basis for not treating the worker as an employee.
Revenue Act § 5430(a)(1)(A)-(C). A taxpayer has a reasonable basis for not treating an individual as an employee if the basis is founded on (a) judicial precedent or specific technical rulings; (2) the result of a past examination or audit involving a substantially similar position; or (3) the long-standing recognized practice of a significant segment of the industry in which the individual is engaged. Revenue Act § 5430(a)(2)(A)-(C). An employer who is unable to meet these specific safe harbor rules may nevertheless be entitled for relief if it can demonstrate in some other manner a reasonable basis for not treating the individual as an employee. Moreover, the reasonable basis requirement is to be construed liberally in favor of the employer. See Rev. Proc. 85-18, 13 I.R.B
For more information on attorneys fees, or other contractual issues, please contact either Lawrence Inouye or Colleen Sechrest at 310.712.0100 or send an email to: linouye@shiotani-inouye.com or csechrest@shiotani-inouye.com.