Monday, October 15, 2007

Independent Contractor or Employee? Choose Wisely.

Article complements of Dawn D. Fleming, ESQ. of Pre-paid Legal Services at 714-606-3520 or visit

A letter from the IRS arrives informing you that your business has been selected for a tax examination to determine whether or not your workers have been rightfully treated as independent contractors. At stake is the possibility that your business will owe large sums of money in interest, penalties and back taxes for failure to remit employment tax withholdings to the IRS that you should have deducted from your workers’ paychecks but failed to. Add to these sums the cost of accounting and legal defense fees to protect your interests during the IRS examination. The result could be financially devastating to you and your business. If the business is a corporation and you think the liability limitation will protect you, think again. If the business files for bankruptcy protection the debt is not dischargeable, the IRS debt will haunt you personally. There are ways to prevent this nightmare scenario.

There is no single fact, but rather three categories of inquiry that the IRS reviews to determine the status of a worker. They are (i) behavioral control, (ii) financial control, and (iii) the relationship between the parties. Behavioral control is determined by whether the business has the right to direct and control the work. IRS looks to see the level of instruction and training a worker receives. Does the company dictate how, when or where the work is to be done? What tools and equipment are to be used? Where to purchase supplies? Financial control looks at factors like expense reimbursement, opportunity for profits or losses and whether there is a significant investment by the worker.

The last category may be the most important: the relationship between the parties. Here the inquiry is: how do the business and the worker view each other? If the worker receives employee benefits such as vacation, insurance and retirement, the implication is the worker is an employee. Conversely, however, just because no benefits are received does not mean the worker is an independent contractor. It is important to note that if a written contract between the parties exists, it allows them to demonstrate the intent of the parties to the IRS. The existence of this document alone could save a business from the scenario above by expressly spelling out that a worker is an independent contractor. A well-drafted Independent Contractor Agreement will also incorporate all the factors listed above to cement the position taken by the parties.

Additionally, a safe harbor for businesses exists, called “relief”. A business will not be liable for back taxes, interests and penalties even if the worker is later determined to be an employee as a result of the tax examination. Businesses are eligible for relief from having to pay these back sums if three requirements are met: (i) reasonable basis (ii) substantive consistency; and (iii) reporting consistency. Essentially, if you relied on the tax advice of an accountant or attorney, a Federal Tax court case, an IRS ruling or industry custom as the reason for treating a worker as an independent contractor, then the reasonable basis requirement is met. Substantive consistency means that similarly situated workers are all treated the same. You can’t pick and choose treating some workers as employees and some as independent contractors if they do the same work. You must file a 1099-MISC for each worker unless they earned less than $600. If you file 1099-MISC for some workers, but not others, relief is only available for workers to whom these forms were issued. To make it easier on employers, a business may complete and submit Form SS-8, which requests the IRS to make a determination of the proper classification of a worker. Visit for more information on this subject.