When I speak with location independent entrepreneurs and expats, the issue of employee vs contractor frequently comes up.
There is no uniform test to distinguish employees from independent contractors. Government agencies such as the IRS, the U.S. Department of Labor (DOL), and the National Labor Relations Board (NLRB) each look at their own set of factors. The same is often true of the state where the business is located.
While the tests for determining a worker’s classification differ, there is a common thread: Definitive answers can be difficult to find.
What’s the difference between the classifications? Why does it matter?
The IRS has long had a voice in the categorization discussion. In 1987, based on an examination of cases and rulings, the IRS developed a list of 20 factors to consider when determining whether a worker should be classified as an employee or independent contractor. The IRS’ next steps included the identification of three categories of evidence that may be relevant in the determination — Independent Contractor (Self-Employed) or Employee?:
- Behavioral control — Is there a written agreement between the parties? Who controls what the worker does and how the worker does his or her job? Is it the company?
- Financial control — Who provides the tools and supplies? Who controls how the worker is paid? Can the worker perform work for other businesses? Who provides the materials? Where is the work to be performed?
- Relationship of the parties involved — Is the worker entitled to benefits (i.e., pension plan, insurance, vacation pay, etc.)? Who is to perform the services? Can assistants be engaged? If so, with approval?
The IRS identifies 20 common-law factors for deciding whether someone is an employee rather than an independent contractor in Rev. Rul. 87-41. The general focus is whether a business has the right to direct and control the worker’s actions. The revenue ruling is still valid.
One of the important things to remember regarding the IRS factors is there is no definitive way of determining whether a worker has been properly classified. However, the IRS does provide potential relief from possible payroll tax exposure based on Section 530 of the Revenue Act of 1978, P.L. 95-600. In order to have this protection, a business must meet all of the following tests:
- Reporting consistency;
- Substantive consistency; and
- Reasonable basis.
The IRS has provided detailed information regarding this relief in Publication 1976, Do You Qualify for Relief Under Section 530? The IRS recently announced that beginning in 2020, instead of reporting compensation for independent contractors on Form 1099-MISC, Miscellaneous Income, employers should expect to use a new form, 1099-NEC, Nonemployee Compensation. This will provide the IRS an easier way to track independent contractors.
But why does this matter? In a nutshell, employees receive a Form W-2, Wage and Tax Statement, and are taxed on this income at the federal and state levels. Employers must withhold these income taxes from employee paychecks and remit them to the IRS on the employee’s behalf. These aren’t the only taxes that are withheld, though. Employers must also withhold Social Security and Medicare taxes (together known as the Federal Insurance Contributions Act [FICA] taxes). The FICA tax is 15.3%, and the employer and employee each pay 7.65%. Then, there is the Federal Unemployment Tax Act (FUTA) tax. Only the employer pays FUTA tax; it is not deducted from the employee’s wages. The FUTA tax rate is 6.0%.
It’s easy to understand why businesses, from a financial perspective, might prefer workers classified as independent contractors: they wouldn’t have to pay income tax withholding and would not be liable for 50% of the FICA taxes and 100% of FUTA taxes for the worker, and the reduction in benefit expenses is an added bonus.
To help with the classification, firms and workers can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. Workers file most Form SS-8s, however, and a formal determination is sent to both the payer and worker and will be binding with the IRS.
Changing economies don’t fit the mold
The traditional factors used to assess worker classification do not translate easily in today’s economy given how businesses are changing their models to offer different services to customers. For example, do you still get into your car, drive to the grocery store, shop, check out and drive home? Or do you download your favorite grocery store’s app, add your items to your virtual shopping cart, press the “submit button,” and wait a few hours for those groceries to arrive on your doorstep? Is the worker who shopped and delivered the items to you an employee of your favorite grocery store? Or is he an independent contractor? Traditional classification criteria might not result in the perfect answer.
A new gig for the gig economy
The gig economy is expanding rapidly as internet platforms are used more to connect service providers to customers. The gig economy generally includes industries in which workers complete tasks on an on-demand or client-by-client basis, such as Uber and Lyft drivers or restaurant home-delivery services. The emerging gig economy has raised questions about how to classify workers for tax purposes.
Legislation at play
Many states use some form of an “ABC test” to aid businesses in the classification of a worker. California has a notable adoption of an ABC test that garnered mainstream attention in the state’s Supreme Court ruling in April 2018 in the case of Dynamex Operations West, Inc., v. Superior Court. The ruling established that companies must use a three-pronged test to determine how to classify workers. This test assumes that workers are employees unless the company that hires them can prove otherwise.
In September 2019, California legislatively followed up on the decision with the passage of Assembly Bill 5 (AB-5), popularly known as the “gig worker bill.” Effective Jan. 1, 2020, the law requires companies that hire independent contractors to reclassify those workers as employees, with a few exceptions.
Many states have started to pattern themselves after California, and we may see in the upcoming year many state legislatures engaged in renewed or new discussions regarding the gig economy.
In related federal news, on Jan. 9, 2020, the IRS released IR-2020-04 and announced the launch of a new Gig Economy Tax Center on IRS.gov to help people involved in the gig economy area meet their tax obligations.