By Kathy Mort, CPA, Pittsburgh, and Megan Marlin, J.D., LL.M., Washington
July 1, 2016
Editor: Annette B. Smith, CPA
Determining whether a worker is properly classified for tax purposes as an independent contractor or an employee is complex. The fact-intensive nature of this inquiry is complicated because the criteria and methodologies used by the IRS to assess a relationship between the service provider and the service recipient often differ from those used by other federal or state government agencies, including the U.S. Department of Labor (DOL) and the National Labor Relations Board (NLRB).
For federal employment tax purposes, this issue generally relates directly to a business’s liability for payroll taxes: federal income tax withholding; Social Security and Medicare (together, Federal Insurance Contributions Act (FICA)); and Federal Unemployment Tax Act taxes. However, worker classification has a broader, significant impact. It affects a worker’s entitlement to pension, health, and welfare benefits; the applicability of minimum wage and overtime provisions; and a worker’s ability to claim unemployment, workers’ compensation, and disability coverage.
Further, since enactment of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, there have been concerns over the impact that worker misclassification may have on an employer’s potential liability under Sec. 4980H. That section generally provides that applicable large employers, i.e., those with at least 50 full-time employees, are subject to an excise tax if at least one full-time employee is certified as having enrolled in a qualified health plan for which a premium tax credit or cost-sharing reduction is allowed or paid (i.e., via a health care insurance exchange). As a result, employers that already face substantial exposure for employment tax liabilities also may be subject to significant excise tax assessments under PPACA for misclassification.
Common Law Standard
Congress adopted the common law standard in defining “employee” for FICA purposes in 1948 (Sec. 3121(d)(2)), rejecting an economic-reality test (see S. Rep’t No. 1255, 80th Cong., 2d Sess. 3-4 (1948)). Under common law, the treatment of a worker as an independent contractor or as an employee originates from the legal definitions developed in the law of agency—whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent. Following the common law standard, the employment tax regulations provide that an employer-employee relationship exists when the party for whom the services are performed has the right to direct and control the worker who performs the services. This control refers to direction over the result to be accomplished as well as how that result is accomplished.
In the context of an IRS examination, employment tax specialists probe the relationship between the service provider and the service recipient to ascertain the degree of control. The IRS approach to analyzing classification of workers has changed infrequently over the years. Historically, when determining worker status, examiners have referred to 20 factors identified in court decisions and published in Rev. Rul. 87-41. In 1996, the IRS revised its training program for agents, suggesting that their audit approach should take into account changes in the workplace and the corresponding changes in the relevancy and emphasis of factors that are most persuasive. The methodology adopted in those materials is still used today.
Agents evaluate three categories of evidence: behavioral control, financial control, and the relationship of the parties. Behavioral controlfocuses on facts that illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is engaged, such as instructions and training. Financial control focuses on facts that illustrate whether there is a right to direct or control how the business aspects of the worker’s activities are conducted, such as whether the worker makes a significant investment,has unreimbursed expenses,whetherservices are available to the relevant market,the method of payment,and the opportunity for profit or loss. In assessing the relationship of the parties, agents focus on facts that illustrate how the parties perceive their relationship, such as intent of the parties expressed in contracts, employee benefits, terms of discharge or termination, and the regular business activity.
The IRS continues to emphasize publicly that it intends to pursue worker misclassification in employment tax examinations and has made numerous announcements about its combined efforts with states and the DOL to curb misclassification. At the same time, IRS enforcement is limited by certain restrictions.
Section 530 Relief
Section 530 of the Revenue Act of 1978, P.L. 95-600, is a relief provision for employers that unintentionally misclassify employees. Perhaps most notably, if Section 530 applies, a business may continue to treat workers as independent contractors, and the IRS cannot retroactively classify certain individuals as employees. A lesser-known provision of Section 530 provides that, except with respect to certain technical service workers, the IRS is barred from issuing regulations or revenue rulings pertaining to worker classification (Revenue Act of 1978 §530(b)). As a result, the IRS cannot issue new revenue rulings or even modify existing revenue rulings to reflect new developments.
Legislators have regularly introduced bills to address worker misclassification. For example, the Fair Playing Field Act of 2015, S. 2252, would require the IRS to offer guidance on the distinctions between employees and nonemployees, end the moratorium on the IRS’s prospectively reclassifying workers, retain the Section 530 safe harbor, and require employers to notify independent contractors of their tax obligations. The Payroll Fraud Prevention Act of 2015, H.R. 3427, would make changes to the Fair Labor Standards Act and impose additional employer reporting requirements and new penalties for misclassification, similar to the Employee Misclassification Prevention Act, S. 3254, which was introduced in 2010. While it seems unlikely that bills on worker classification will be enacted this year, these and other legislative initiatives highlight ongoing concerns from a policy perspective about worker misclassification.
Many commenters recently have called for recognition of a new, third worker category, in addition to employees and independent contractors, to reflect the increased growth in on-demand worker platforms. The common law has been the standard for analyzing worker classification for nearly 80 years, and the most recent IRS guidance that agents use to apply that standard is 20 years old. The passage of time has not eased the difficulty or decreased the number of ongoing disputes regarding worker classification. In fact, complexities inherent to the issue seem to be magnified as the business and technology environments change the relationships between service providers and businesses.
Forbes reported in late 2014 that an estimated 53 million Americans—approximately 34% of the total workforce—were freelancers, and that number was expected to increase to 50% by 2020 (see Wald, “5 Predictions for the Freelance Economy in 2015,” Forbes.com (Nov. 24, 2014)). The freelance workforce also is evolving as increasingly sophisticated systems enable businesses to respond to the market’s desire for nontraditional work arrangements. The freelance workforce, often referred to as the “gig economy,” is expanding rapidly because internet platforms can be used to connect service providers and service recipients to provide service on demand. The gig economy generally includes industries in which workers complete tasks on an on-demand or client-by-client, as-needed basis, such as drivers and technicians, grocery or restaurant delivery services, and marketing. The emerging gig economy again has raised questions about how to classify workers for tax purposes.
The traditional factors used to assess worker classification do not translate easily to modern platforms that connect parties who want to provide services with those who request services. In every relationship where services are provided, of course, there is some degree of control by the service recipient and some degree of autonomy on the part of the service provider. In gig economy arrangements, factors that can point to contractor status, depending on a full analysis of all facts and circumstances in each situation, include that the freelancers may be able to set their own work schedules and have a right to decline work. They may be subject to little to no oversight or evaluation when they perform services and may be in a position to negotiate their pay.
Other factors may indicate an employment relationship, such as that freelancers often have little control over the method and means of payment and client choice, may not hold themselves out as being “in the business,” may have little investment in materials and tools, or do not advertise their services. While there has been litigation in several states on these issues under state law, it remains to be seen how these relationships will be viewed by the IRS and whether these emerging economic relationships may trigger a fresh look at how workers generally are classified (see O’Connor v. Uber Technologies, Inc., No.4:2013cv03826 (N.D. Cal. 8/16/13) (complaint filed), and Silver v. Unemployment Compensation Bd. of Rev.,34 A.3d 893 (Pa. Commw. Ct. 2011)).
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.