Independent contractor versus employee: the risks of reclassification

Business Horizons, Nov-Dec, 1997 by Renee D. Robbins, J. A. DeFatta

Evaluating and classifying workers' employment status properly can save time, money, and resources spent in fines or litigation.

Growing domestic and international competition has forced U.S. firms to find ways to prune operating costs while still remaining productive and efficient. Downsizing and reengineering are becoming standard operating practices. Many firms have achieved their objective of reducing labor costs (direct wages and employee benefits) by terminating "employees" and rehiring them as "consultants" or "independent contractors." However, there can be major legal and tax risks associated with such practices if they violate the Internal Revenue Service's definition of an employee.

One of the IRS's most controversial issues in recent years is the reclassification of a worker's status from an employee to an independent contractor. The IRS claims it loses millions of dollars each year due to such improper classifications, particularly with the number of independent contractors in the U.S. at five million and rising. An advantage of labeling a worker as an independent contractor is that it lowers an employer's tax obligation, since the employer does not have to pay the contractor's Federal Insurance Contribution Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes. Moreover, administrative costs of complying with the tax laws are greatly reduced because the employer is not required by law to provide employee benefits (vacation pay, sick leave, health insurance, pension contributions) to an independent contractor.

One of the most perplexing aspects of the debate is the legal view regarding how a worker should be classified. The common law classification between the two types is often contradictory and vague. No single rule or test distinguishes whether a worker is an employee or an independent contractor. This is primarily because the relationship between a company and its workers is unique. Every decision of whether a worker is an employee or a contractor must be made on a case-by-case basis.

Classifying employment status properly is crucial in applying the proper tax provisions. Three main areas are affected by the difference in the classification of a worker:

1. Employment Taxes. If workers are classified as employees, the employer is responsible for paying federal tax withholdings, FICA taxes, and FUTA taxes on them. However, if they are classified as independent contractors, they are deemed to be their own "employers," so taxes are not withheld from the payment received for services rendered. Instead, they are subject to the tax imposed by the Self-Employment Contributions Act. An independent contractor must pay self-employment taxes on income earned in that capacity, determining the amount owed to the IRS by completing Form SE, which is filed with his individual income tax return.

2. Employee Business Expenses. Under IRS Code Sec. 162, employees may deduct certain business expenses that are not reimbursed by an employer, but only to the extent that they exceed 2 percent of the adjusted gross income. The business expenses are classified as miscellaneous itemized deductions and are deductible "below the line." Conversely, an independent contractor can deduct business expenses directly from gross income ("above the line"), and the expenses are not subject to a 2 percent floor.

3. Employee Benefits. Employers are required by law to consider employees in applying benefit plan rules and requirements. Code Sec. 410(b) defines the minimum participation and coverage requirements a plan must satisfy to be eligible to receive favorable tax treatment. If the IRS were to reclassify a company's workers, the employee benefit plan could lose its tax qualification retroactively.

Statutory Classification

When seeking proper classification, businesses should first look for guidance in the statutes. These provide a safe harbor for those classes of workers specifically defined as either an independent contractor or an employee.

Statutory Employee. The term "employee" is defined in three different sections of the IRS code relating to employment taxes. The Section 3121(d) definition for FICA tax purposes contains the broadest of the three: a corporate officer; an agent or commission driver who distributes meat, vegetables, fruit, bakery goods, beverages (other than milk), laundry, or dry cleaning; a full-time life insurance salesman; a home worker performing work under the specifications of the person who provides the materials or goods, which are required to be returned to such person or a person designated; or a traveling salesman, engaged full-time to solicit orders for his principal. With the exception of the corporate officer, all other classes of these workers must meet three additional requirements as stated in Code Sec. 3121 (d)(3) before being classified as employees for FICA purposes: (1) they must personally and substantially perform all the services for remuneration; (2) they must not retain a substantial investment in the facilities to be used; and (3) they must continue the relationship on an ongoing basis.