Whether or not the Obama administration budget proposal to add some clarity to worker classification sees the light of day, the employee vs. independent contractor issue will surely be undergoing increased scrutiny.

The issue has been around for some time, and has important consequences since federal payroll taxes are imposed only with respect to wages paid to employees, not independent contractors.

First, there were the common law principles delineating who was a worker and who was an independent contractor. Then, the IRS provided a 20-factor control test, based on common law principles, to analyze a worker’s status. And into the mix, Congress added Section 530 of the Revenue Act of 1978 to provide a “safe harbor” for employers to treat a worker as an independent contractor if the service recipient has a reasonable basis to do so and certain other requirements are met.

Since 1978, the provision has served to preclude the IRS from issuing general guidance addressing worker classification. Hence, the effort in the budget to permit the IRS to require prospective reclassification of workers whom the IRS deems to be currently misclassified. 

“It’s an area that is going to be more closely scrutinized, since there’s the perception that employers are attempting to circumvent payroll taxes by classifying workers as independent contractors,” said John Wollenberg, director of tax services at Friedman LLP. “But it’s also an area in which there has been controversy and uncertainty for many years.”

There are some advantages of independent contractor status for both sides. The advantage to the worker is that he can establish self-employed retirement plans and deduct certain expenses that would otherwise not be deductible. The advantage to the employer is the saving of payroll taxes, as well as the convenience of issuing a Form 1099 instead of a W-2. In addition, misclassification allows employers to avoid having to comply with a number of federal and state laws regarding employment practices, and to avoid the scrutiny of federal workplace protection laws.

Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS to clarify in advance whether a worker is an employee, noted Wollenberg.

A written consulting agreement can be also useful, with language coordinated with the 20-factor test. “If the agreement reflects some of the factors that the IRS weighs in its determination, it can strengthen your position that the worker is an independent contractor,” he said.

“The problem here is that it’s such a subjective issue,” said John Barrie, a tax partner at Bryan Cave LLP. “Under Section 530 if you treat someone in good faith as an independent contractor and meet your reporting obligations, then you’re protected. The theory is if you’re issuing Form 1099s, there shouldn’t be a tax gap issue, since to the extent that workers are getting 1099s it’s easy enough to match and find out if they’re reporting their income.”

The budget proposal basically says that Section 530 will protect you, but if you’re challenged there’s no prospective relief, Barrie observed. “In fighting the issue, you have to look at the dollars involved,” he said. “If you challenge and lose, you now have a liability on the books that has to be reported and can affect your ability to borrow. There are situations where a company may have good arguments, but from an economic standpoint it cannot afford to fight.”

Although the budget proposal is scored to raise a significant amount of revenue, the view of the business community is that it would have an adverse impact, Barrie indicated. “The business community sees Section 530 as a protection allowing them to hire with a relative sense of confidence,” he said. “Repeal might have the effect of putting a damper on job expansion.”

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