December 4, 2021 - Lumin Law

It’s critical for your business to periodically review the status of its workers to ensure they are properly classified as either employees or independent contractors. Your business will have significantly different obligations depending on whether the worker is classified as an "employee" or an "independent contractor."

For workers classified as employees, your business must withhold federal income tax, social security taxes, and federal unemployment taxes. You may also need to provide employees with health insurance and other fringe benefits. For Washington businesses, there are also unemployment insurance and workers compensation obligations. Other states may have different tax obligations.

But, for workers classified as independent contractors, the business has none of these responsibilities. It simply pays them for their services and sends them a Form 1099-MISC (if the amount is $600 or more). That’s it.

Who is an "employee"?

This stark contrast between how employees and independent contractors are treated means the business must engage in a high stakes analysis to determine who is an employee?

Unfortunately, there is no uniform definition of the term. The question of whether a worker is an employee for federal income and employment tax purposes is complex and intensely factual. And because of the related tax obligations, the stakes can be very high.

Right to Control

Workers are generally employees if the employer has the right to control and direct them regarding the job they do and how they do it. The employer doesn’t actually have to direct or control how the services are performed; it’s enough if the employer has the right to do so. Otherwise, the workers are independent contractors.

Factors to Consider

The IRS usually examines the following factors to see if the employer has the right to direct and control the worker:

1. A worker who must comply with instructions about when, where, and how he must work is ordinarily an employee. This control factor is present if the business has the right to make the worker follow instructions (regardless of whether you exercise that right).

2. Training a worker by teaming an experienced employee with the worker, by corresponding with the worker, by requiring her to attend meetings, or by using other methods, indicates the business wants the services performed in a particular method or manner. Ongoing training is a particularly strong sign of an employer-employee relationship, but orientation or information programs about company policies are not.

3. Integration of the worker’s services into the business operations generally shows the worker is subject to the direction and control of the business.

4. If the services must be rendered personally, the business probably is interested in the methods used to accomplish the work as well as in the results, indicating an employer-employee relationship.

5. A business that hires, supervises, and pays assistants for a worker is exhibiting employer-like control over the worker on the job. Conversely, an independent contractor relationship is indicated if a worker is contractually obligated to hire, supervise, and pay assistants.

6. A continuing relationship between the worker and the business indicates an employer-employee relationship exists. A continuing relationship may exist where the worker is called in at frequently recurring, although irregular, intervals.

7. The fact that a business requires work to be performed on its premises suggests control over the worker (if the work could be done elsewhere). Work done off the premises, such as at the worker’s office, indicates some freedom from control. The importance of this factor depends on the type of services involved and whether an employer generally would require employees to do similar work on its premises.

8. A business exhibits control over a worker if it requires her to perform services in a specific order or sequence.

9. A business’s requirement that the worker submit regular or written reports indicates a degree of control over the worker.

10. Payment by the hour, week, or month generally points to an employer-employee relationship, if this method of payment isn’t just a convenient way of paying a lump-sum agreed upon as the cost of a job. Payment by the job or on a straight commission basis generally indicates a worker is an independent contractor.

11. A business exhibits the characteristics of an employer if it supplies a worker with significant tools, materials, and other equipment, or ordinarily pays the worker’s business or traveling expenses.

12. A worker exhibits independent contractor status if he invests in facilities that aren’t typically maintained by employees (e.g., renting his own office). By contrast, an employee usually relies on the employer to provide the facilities needed to do the job.

13. A worker who can realize a profit or suffer a loss as a result of her services generally is an independent contractor, but a worker who can’t is an employee. The risk that a worker won’t be paid isn’t factored in.

14. A worker who performs more than minimal services for a number of unrelated businesses at the same time generally is an independent contractor. However, a person who works for more than one business may be an employee of each business, especially where the businesses are part of the same service arrangement.

15. The fact that a worker makes her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.

16. The right to fire a worker is a factor indicating that he is an employee. An independent contractor, on the other hand, can’t be fired as long as he produces the work that the business contracted for.

Classify Workers Properly from the Start

There is no clear test for exactly how many of these factors must be satisfied, nor are these factors uniformly applied. Proper worker classification is a highly contested topic between taxpayers and the IRS. That's why it's so important that you properly classify your workers from the start.

Lumin Law can help with this analysis. Reach out and connect with us to discuss how these complex rules apply to your business and to ensure that all your workers are properly classified.

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What if Workers are Classified Wrong?

What if you've reviewed the IRS factors and think maybe a worker is classified wrong? You're not the first business owner to get a knot in your stomach after reading through that list.

Fortunately, the IRS has developed a program that allows a business to resolve past worker classification issues by voluntarily reclassifying their workers without undergoing an audit.

Voluntary Classification Settlement Program

The Voluntary Classification Settlement Program (VCSP) is an employment tax settlement program offered by the IRS that allows a business to reclassify as employees those workers it erroneously treated as independent contractors. The program has generous payment terms, and participants get relief from employment tax audits for previous years.

Who is Eligible?

The VCSP is available to taxpayers who have consistently treated their workers (or a group of their workers) as independent contractors and now want to begin treating them as employees. To be eligible, the taxpayer must have filed all required Forms 1099 for the workers for the previous 3 years within 6 months of the Form 1099 due dates (including extensions).

A taxpayer who is currently under an IRS employment tax audit isn’t eligible for the program. Similarly, a taxpayer who is under audit for worker classification issues by the IRS, the Department of Labor (DOL), or a state government agency is ineligible. However, a taxpayer that was previously audited by the IRS or the DOL for worker classification is eligible if it has complied with the results of that audit.

If a corporate taxpayer’s parent, subsidiary, or other member of its consolidated group is under audit, then the taxpayer can’t participate in the VCSP. An audit of one member of a taxpayer’s consolidated group is treated as an audit of the taxpayer for these purposes.

Terms of the Program

Once accepted into the VCSP, the taxpayer must agree to treat the class of workers as employees for future tax periods. The taxpayer must also agree to allow the IRS an extra 3 years to assess employment taxes. This extension applies for the first 3 calendar years beginning after the agreement takes effect.

In exchange for making these concessions, the taxpayer gets the following benefits:

1. The taxpayer must pay only 10% of the employment tax liability on compensation paid to the workers for the most recent tax year, determined under reduced rates (see “Figuring the Payment,” below);

2. The taxpayer won’t be liable for any interest and penalties on the employment taxes; and

3. The taxpayer won’t be subject to an employment tax audit for the classification of the workers for prior years.

Taxpayers may choose to reclassify some or all of their workers. However, once a taxpayer chooses to reclassify certain workers as employees, it must treat all workers in the same class as employees.

Figuring the Payment

The payment due under the VCSP is 10% of the employment taxes, calculated under reduced rates, on the compensation paid to the reclassified workers in the most recently completed tax year, determined at the time the VCSP application is filed.

If you apply for the VCSP in 2022, the most recently completed tax year will be 2021. The reduced rate is 10.68% of compensation up to $142,800 (the social security wage base for 2021; the wage base for 2022 is $147,000) and 3.24% of compensation above $142,800. You’ll pay only 10% of that amount.

Illustration: A company paid $1.5 million in 2021 to workers that are the subject of a VCSP application. None of the workers were paid more than $142,800 in wages. The company submits its application on October 1, 2021. It wants to begin treating the workers as employees on January 1, 2022. The company calculates the payment due based on amounts paid to the workers in 2021, because 2021 was the most recently completed tax year when the application was filed. Under the reduced rates, the employment taxes on $1.5 million of wages would be $160,200 (10.68% of $1.5 million). The company’s VCSP payment would be 10% of $160,200, or $16,020.

Procedure to Apply

Taxpayers apply to participate in the VCSP by filing Form 8952 with the IRS at least 60 days before the date they want to begin treating the workers as employees. No payment should be made at that time. After the IRS reviews the application, it will contact the taxpayer, or the taxpayer’s authorized representative, to complete the process.

Taxpayers who are accepted into the VCSP must enter into a closing agreement with the IRS. Full payment is due when the taxpayer returns the signed closing agreement to the IRS.

Should you participate?

Although the VCSP’s terms are generous, any decision to participate must be made carefully, after weighing the costs and benefits. Agreeing to treat workers as employees may have far-reaching consequences under a variety of federal and state statutes. The right choice may depend on how clear it is that the workers are in fact employees.

Let's discuss the pros and cons of participating in the VCSP for your specific situation and help you determine how to proceed. Please reach out and arrange a time for us to connect.