All too often, adult business operators spend so much time focusing on things such as obscenity, record-keeping and intellectual property that they neglect some important corporate issues, including taxation and employment law, which can have a tremendous impact on a business owner.
Make no mistake about it, adult business operators need to be concerned with obscenity, record-keeping and intellectual property, but at the same time, they should not be forgetting about some other very important areas of corporate law.
Every year around tax season, my office receives numerous telephone calls from clients (individuals and businesses) with concerns related to their own worker status or the worker status of someone providing services on their behalf. The classification of a worker as an employee or independent contractor is very important and any misclassification can create numerous issues.
As you read through this article, it is essential to remember that you should always consult with your own attorney and accountant when it comes to employment law and taxations issues. Additionally, the IRS’ website, IRS.gov, contains a library of material that should be used as a resource for employers, employees and independent contractors.
Please note that this article is based on U.S. federal tax law and that each individual state, district or commonwealth has its own set of tax laws that will govern the employer/worker relationship, including classification, determination and penalties for misclassification.
Independent Contractor Or Employee (It’s All About Control)
The classification of a worker as an employee or independent contractor in many cases can be quite complex. A worker that needs to be classified as an employee occurs when the employer can control what will be done and how it will be done.
According to the IRS website, under the common-law rules, facts that provide evidence of the degree of control and independence fall into three categories; 1) behavioral (“does the company control or have the right to control what the worker does and how the worker does his or her job?”; 2) financial (“are the business aspects of the worker’s job controlled by the payer?”; and 3) type of relationship (“are there written contracts or employee type benefits”).
In order to assist employers decide whether a worker is an employee or an independent contractor under the common law rules, the internal revenue service created Revenue Ruling 87-41. Revenue Ruling 87-41 was written based upon the internal revenue service’s examination of previous cases and rulings and provides for 20 factors to consider when evaluating a worker’s status. . Revenue Ruling 87-41 was developed as a guide, and not all of the factors must be present to determine the existence of an employee relationship. The 20 factors are meant to be utilized as a guide to assess the likelihood as to whether an individual is an employee or independent contractor.
Per the Joint Committee on Taxation (“Present Law and Background Relating to Worker Classification for Federal Tax Purposes,” May 7, 2007), the 20 factors identified by the IRS are as follows:
(1) Instructions. If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
(2) Training. Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
(3) Integration. Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
(4) Services rendered personally. If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
(5) Hiring, supervising and paying assistants. If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
(6) Continuing relationship. A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
(7) Set hours of work. The establishment of set hours for the worker indicates employee status.
(8) Full time required. If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
(9) Work done on premises. If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
(10) Order or sequence set. If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
(11) Oral or written reports. A requirement that the worker submit regular reports indicates employee status.
(12) Payments by hour, week or month. Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
(13) Payment of expenses. If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
(14) Furnishing of tools and materials. The provision of significant tools and materials to the worker indicates employee status.
(15) Significant investment. Investment in facilities used by the worker indicates independent contractor status.
(16) Profit or loss. A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
(17) Working for more than one firm at a time. If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
(18) Making services available to the general public. If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
(19) Right to discharge. The right to discharge a worker is a factor indicating that the worker is an employee.
(20) Right to terminate. If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.
Why The Temptation For Misclassification?
From an employer’s taxation perspective, it is cheaper to pay independent contractors than employees. An employer is required to file a form W-2 for each employee and is required to pay social security, Medicare and unemployment taxes for its employees. However, as a 1099’d independent contractor, an employer does not have to pay the taxes. Thus, it can be very tempting for employers to misclassify its employees in order to save some money.
Consequences Of Misclassification
Under U.S. federal law, the penalties for misclassification of an employee as an independent contractor without a reasonable basis for doing so can be quite severe. The reason why the U.S. government cares so much is because the misclassification of an employee as an independent contractor results in the employer not deducting and withholding applicable taxes (in essence, the government gets upset because it is being deprived of tax revenue, including payroll, social security, Medicare and unemployment insurance taxes). In the event that the IRS reclassifies an employee that was claimed as an independent contractor, the government can impose substantial fines, penalties and back-taxes. Normally the employer is liable for these penalties.
Need Some Help?
If you are unable to determine on your own whether someone is an employee or an independent contractor the party seeking a determination can file Form SS-8 Determination of Worker Status for Purposes of Federal Taxes and Withholding. Both the business or the worker can file Form SS-8. The benefit of filing Form SS-8 is that the internal revenue service will give you a definitive answer on the classification of the worker. The bad news is that it can take a very long time for the IRS to provide you with their determination. Per the internal revenue service’s website, it can take at least six months to receive a determination.
What If You Got It Wrong?
If you misclassify an employee as an independent contractor with no reasonable basis to do so you are most likely facing some stiff back taxes and fines. However if you had a reasonable basis for the misclassification you may have some potential relief and you should contact your accountant or tax lawyer right away. More recently, the IRS created a program called the Voluntary Classification Settlement Program.
According to the IRS website, under this program “employers can reclassify their workers as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees.
To participate in this new voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. More information regarding the Voluntary Classification Settlement Program can be found by visiting: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Voluntary-Classification-Settlement-Program.
The proper classification of your workers is an important part of running a business that complies with U.S. tax laws. While it can be tempting for an employer to save a few bucks by misclassifying a worker as an independent contractor, the severe potential financial penalties are simply not worth the risk. If you are an employer or worker and believe that misclassification has taken place, there may be some limited relief available and you should contact your accountant or tax attorney immediately.
This article does not constitute legal or tax advice and is provided for your information only and should not be relied upon in lieu of consultation with legal advisors in your own jurisdiction. It may not be current as the laws in this area change frequently. Transmission of the information contained in this article is not intended to create, and the receipt does not constitute, an attorney-client relationship between sender and receiver.
Originally published on XBIZ.