IRS Reemphasizes Proper Worker Classification

The Internal Revenue Service recently issued a bulletin reiterating its focus on correctly classifying workers as either employees or independent contractors. This IRS bulletin is the most recent of several similar publications by federal agencies, underscoring the priority the current administration is giving to enforcing proper worker classification. The bulletin also serves as an important reminder for employers to evaluate their own classification decisions.

According to the IRS bulletin, to determine whether a worker is an independent contractor or an employee for federal tax purposes companies should use the common law “control test.” This test looks at the degree of control the employer has over the worker. The bulletin breaks down the control test into three categories—Behavioral Control, Financial Control, and the Relationship of the Parties—and advises businesses to consider all the facts as they relate to each category.

  1. Behavioral Control. Businesses should examine the degree to which they control or direct, or have the right to control or direct, what tasks the worker performs and how he or she performs them. For example, if the business provides instruction or training on how to perform tasks, that could indicate control over the worker’s behavior. Likewise, if the business supervises and directs the daily activities of a worker, this weighs in favor of the worker being considered an employee. If, however, the business gives the worker a task to complete and lets the worker decide how and when to complete it, this points more towards an independent contractor relationship.
  2. Financial Control. The focus of this factor is whether the business has a right to control the financial and business aspects of the worker’s job. Factors to consider include whether: the business decides how the worker is paid; the business reimburses the worker for business expenses; the business provides the tools and equipment needed for the job; the worker is permitted to (and does) perform similar services for others; and the worker is able to realize profit or incur losses. For example, an employee generally is given equipment, tools, and office space needed to perform his or her work, whereas an independent contractor is more likely to furnish these items him- or herself.
  3. Relationship of the Parties. This element concerns facts that indicate the type of relationship between the business and the worker. Questions the business should ask include: Are there any written contracts describing the intended relationship between the parties? Does the business provide the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay? Are the workers’ services a key aspect of the company’s regular business? And, how long is the business relationship intended to last? If, for example, the duration of the relationship is open-ended or undefined, this points toward an employee classification. But if the relationship is for a fixed term, such as the completion of a specific task, this weighs in favor of an independent contractor relationship.

Businesses should keep in mind that no single factor is determinative. Rather, they must weigh each factor and consider the totality of the circumstances.

The potential exposure for businesses that misclassify their workers is substantial. In addition to being liable to the IRS for back income, social security, and other taxes, employers could find themselves on the hook to the Department of Labor (DOL) for unpaid overtime wages; to state revenue and labor departments for their respective shares of back taxes; to each federal and state agency involved for interest and penalties; and to plaintiffs in civil lawsuits for unpaid wages and damages. Additionally, an incorrect classification decision could have other undesirable implications, such an obligation to provide health insurance under the Affordable Care Act.

For employers who believe they may have incorrectly classified their workers, the IRS offers a Voluntary Classification Settlement Program, which provides partial relief from penalties and back taxes for employers that agree to reclassify their workers as employees going forward and meet other eligibility requirements.

The IRS bulletin comes on heels of a DOL memorandum that offered its own guidance on worker classification. Although the IRS and DOL are working together in a joint initiative to address worker classification issues, the agencies’ memoranda seem to offer conflicting guidance. Specifically, the IRS bulletin states the control test is the proper core of worker classification decisions, while the DOL memorandum seems to suggest the control test should not be the focus. Rather, according to the DOL, the analysis should look at the “economic realities” of the relationship, including: is the work an integral part of the employer’s business; does the worker’s managerial skill affect the worker’s opportunity for profit or loss; how does the worker’s relative investment (for example, in tools or equipment) compare to the employer’s; does the work performed require special skill and initiative; is the relationship between the worker and the employer permanent or indefinite; and, what is the nature and degree of the employer’s control. Like the IRS, the DOL cautions against analyzing the factors mechanically or over-emphasizing and single factor.

The seemingly inconsistent guidance from these two agencies could leave employers confused as to how to analyze classification decisions. And, unhelpfully, several recent court decisions have used different approaches, too. However, the key takeaway for employers is that they should not hinge their classification decisions on any single aspect of the business-worker relationship; they should instead look carefully at every aspect of the overall relationship.

If you would like assistance determining whether to classify your workers as employees or independent contractors, want more information about the IRS’s Voluntary Classification Settlement Program, or have questions about anything in this article, please contact Andrew Chase at achase@seatonlaw.com or any of the other Peters, Revnew, Kappenman & Anderson, P.A. attorneys.

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