Are you, or your workers, employees or independent contractors? It pays to know the difference.
What is in a label? In fact, why do so many teaching pros — and those who employ them — appear to covet the label of “independent contractor”?
The long-running controversy over properly labeling employees and independent contractors shows no signs of easing. A recent Department of Labor study revealed that 30 percent of businesses “misclassified” employees as independent contractors. A Senate committee hearing labeled the misclassification problem as “staggering.”
Although the Government Accountability Office, the investigative arm of Congress, acknowledges that employee misclassification itself is not a violation of law, far too often it is associated with labor and tax law violations. The government’s response to this growing problem has the Labor Department hiring more investigators to pursue misclassification issues.
The Internal Revenue Service, for its part, is in the midst of a comprehensive National Research Program of payroll audits aimed, in part, at catching employers who fail to withhold or improperly withhold taxes and pay Social Security and Medicare premiums on the wages of workers misclassified as independent contractors. Many states are also reportedly moving on the misclassification issue as well.
Who Is and Who Isn’t?
The IRS uses three characteristics to determine the relationship between businesses and workers — behavioral control, financial control and type of relationship. Misclassification of a worker as a nonemployee can result in liability not only for employment taxes, but also for the 100 percent penalty for failure to collect and account for employment taxes.
At its most basic, the employee-independent contractor controversy boils down to the argument that by labeling a worker as an independent contractor rather than as an employee, an employer can avoid the voluminous paperwork and payroll tax burden. A worker such as a teaching
pro who is an independent contractor can exclude certain types of compensation from income and deduct far more work-related expenses than an employee.
Although the term “independent contractor” is not clearly defined in our tax laws, it is no secret that the self-employed and independent contractors contribute greatly to the ever-increasing “tax gap” — the difference between the taxes owed and the taxes actually paid. In addition to the IRS’s worries about the timely payment of income taxes when an employer is not in the picture, the U.S. Department of Labor frets about misclassified employees unfairly excluded from coverage under key laws designed specifically to protect workers.
It is not always a bad deal for an independent contractor be re-labeled as an employee. After all, a worker may receive employee fringe and pension benefits, may be entitled to reimbursement for business expenses, may be entitled to federal and state minimum wage and hour standards, and may receive coverage under nondiscrimination laws, unemployment insurance and workers’ compensation protection.
On the tax front, several years ago the IRS published guidance for workers paid as independent contractors re-labeled as an employee. What should the worker do?
- Tax Returns and Amended Returns: A worker may have received a Form 1099 and had no reason to report the amount as wages. However if, after filing a tax return, the IRS determines the worker is an employee, the worker must file an amended tax return. In all likelihood the re-classified employee would have overpaid because of the self-employment tax (which is equivalent of paying both the employer and an employee’s share of FICA).
- Schedule “C” Expenses: Most independent contractors include all their income and expenses from their independent contractor business on Schedule C of Form 1040. The bottom line of Schedule C is the net taxable income from the business. For someone who has been reporting independent contractor income on a Schedule “C,” the re-characterization can be messy.
- Changing Returns: According to the tax rules and the IRS, if an independent contractor is re-labeled as an employee, the expenses deducted from income on Schedule C must now be deducted as miscellaneous itemized deductions — subject to a 2 percent floor. What’s worse, some of the expenses may no longer be deductible at all, such as the deduction equal to one-half of the amount of self-employment tax.
- Do-It-Yourself or Have It Done For You: According to the IRS, a re-classified worker taking the initiative to correct matters, usually with an amended tax return, may be able to reduce or avoid any otherwise applicable interest or penalties on taxes due. The re-classified worker might, in fact, receive a refund of any overpayment of tax. And for those who did not initially pay FICA or self-employment taxes, paying it now will ensure credit for this income with the Social Security Administration.
A Safe Harbor From Liabilities?
An employer’s liability for violations of wage and hour laws, discrimination, wrongful termination and similar rules can easily be minimized by not having employees or keeping their ranks to a minimum. And, as some tennis facilities and racquet sports-related businesses have discovered, it is usually possible to have some workers operate as independent contractors, thus sidestepping a panoply of tax and other liabilities — maybe.
Created in 1978, Section 530 of the Tax Code provides relief from re-classification liabilities when an employer misclassifies workers. More than 30 years after this “temporary” provision was enacted, it continues to be interpreted liberally, providing protection when an employer has classified a worker as an independent contractor and the worker is reclassified on audit.
The employer is relieved of liability if the tax returns, including Form 1099, show that all similar workers were consistently treated as independent contractors, and that there was a reasonable basis for that classification. Employers must usually satisfy three requirements: a reasonable basis for treating the workers as independent contractors, a substantive consistency requirement and a reporting consistency requirement.
The IRS has the resources to detect and pursue only a tiny fraction of misclassification situations. In fact, the latest figures available reveal the agency completed examinations of fewer than 1,200 employers. But don’t be lulled into a false sense of security. Remember, it only takes one unemployment insurance “employee” determination to lead to one on workers’ compensation, state disability, IRS issues, etc.
Fortunately, the IRS has a form, SS-8, that is a streamlined ruling form that either workers or an employer can fill out to obtain an IRS determination on worker status. Although the IRS’s SS-8 program is helpful, there is some risk involved. According to the IRS, in fact, 72 percent of all Form SS-8 requests it received resulted in IRS determinations that the workers in question were employees. Twenty-five percent were closed without any advice given. Only 3 percent resulted in determinations that the workers in question were independent contractors. Surprisingly, about 90 percent of Form SS-8 requests are filed by workers — which could explain the skewed numbers. Obviously, employers should be taking advantage of this process more frequently, notwithstanding the figures.
Looking Like an Independent Business
The most fundamental difference between employees and independent contractors is that employers have the right to tell their employees what to do and how to do it. It’s acceptable for an employer to give detailed guidelines for the results expected.
If a teaching pro or other independent contractor runs absolutely no risk of loss, chances are he or she is not really an independent contractor. This can be as simple as charging a set price for a job or engagement. Obviously, if the project price exceeds expenses, an independent contractor will make money; if too little is charged, a loss will result.
It’s also a smart move to look like an independent business. Don’t accept employment benefits; instead charge enough that health insurance, paid vacations or pension benefits are affordable. Independent contractors also find it is a good idea to maintain a separate bank account.
Most importantly, an independent contractor should make his or her services available to more than one person or company. Hanging out a shingle, advertising your services or joining a professional organization all are strong indications of independent contractor status.
The potential liability for mischaracterization of workers is already frightening, and it may become even more expensive. The Obama administration proposed to reform the IRS’s oversight of worker classification in its fiscal year 2011 budget proposals.
There are also proposals to make misclassification penalties more severe both for employers and workers, as well as give more power to the government in cases of misclassification. There are increased audit programs designed to ferret out problems and more employers of all sizes are destined to face such battles.
Short of treating everyone as an employee, there is no easy solution to this problem. It is clear, though, that many tennis businesses do not routinely examine their worker relationships before they are confronted with an IRS, Labor Department or other audit. And workers rarely look beyond the anticipated tax breaks when assuming the independent contractor label.
This is one area in which a little thought, a little preparation and professional guidance can be better than a cure.
An Independent Contractor’s Life
Although the benefits to an employer dealing with independent contractors are largely economic, consider the benefits of a teaching pro working as an independent contractor:
- You are your own boss — complete with all of the risks and rewards. As master of your own fate, independent contractors know that the amount of money they make is directly related to the quantity and quality of their work.
- You may earn more. According to a Wall Street Journal survey a few years ago, independent contractors usually are paid 20 to 40 percent more per hour than employees performing the same work. The employer can afford the independent contractor’s higher rates because they are not required to pay half of the independent contractor’s Social Security taxes, pay unemployment compensation taxes, provide workers’ compensation coverage, or employee benefits.
- An independent contractor’s tax bill will be lower. Being an independent contractor means no federal or state taxes are withheld from paychecks as they are for employees. Although independent contractors must generally make periodic estimated tax payments directly to the IRS, they can hold onto their hard-earned money longer before turning it over to the IRS.
- Even more importantly, an independent contractor can take advantage of many business-related tax deductions that are largely denied to employees. All business expenses, so long as they are ordinary, necessary and reasonable, qualify as tax write-offs. Even commuting expenses, denied to employees, are often legitimate tax deductions for independent contractors when traveling from home.
But there’s also a downside to being an independent contractor:
- No job security. Admittedly, an independent contractor is his or her own boss, but that is often a mixed blessing. Employees usually are paid even if business is slow or there is no work. There are rarely costs associated with dismissing independent contractors.
- No employer-provided benefits. Employers, including many tennis businesses, often provide benefits to employees such as health insurance, paid vacations and paid sick time. More generous employers may also provide retirement benefits, bonuses and even employee profit sharing.
- Independent contractors get no benefits. Each independent contractor must pay for their own health insurance, often at a higher rate than their employer must. Time lost due to vacation and illness comes directly out of an independent contractor’s bottom-line.
- No unemployment income benefits. That’s right, no safety net. Teaching pros labeled as independent contractors can’t collect unemployment when the work for an employer ends.
- No employer-paid workers’ comp. If a work-related injury is the fault of the independent contractor, there is little or no recourse against the employer.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.