A company's obligation to a worker for federal tax purposes depends primarily on whether the worker is an employee or an independent contractor, according to G. J. Stillson MacDonnell, a shareholder at the national labor and employment law firm of Littler Mendelson. "There is no other option," she said.While independent contractor status provides benefits to companies and individuals, it draws hostility from the Internal Revenue Service and state tax agencies, she said.

Since federal employment taxes are imposed only with respect to wages paid to employees, the IRS is the agency responsible for determining whether a worker qualifies as an employee or independent contractor. And since employee status is defined slightly differently for the purposes of the three different employment taxes - FICA, FUTA and income tax withholding - status must be determined separately for the purposes of each, noted MacDonnell, who was formerly chair of the Employment Taxes Committee of the American Bar Association Tax Section.

To complicate matters, professional employer organizations and staffing services have grown tremendously over the last decade to enable clients to cost-effectively outsource the management of human resources, employee benefits, payroll and workers' compensation.

The PEO relationship involves a contractual allocation and sharing of employer responsibilities between the PEO and the client.

There are several factors driving the growth of the industry, according to Edie Clark, director of public relations for the National Association of Professional Employer Organizations, including a significant increase in employment-related federal, state and local laws and regulations, and the level of expertise required to manage a small-to-midsized business.

PEOs differ from employee leasing in that PEOs involve all or a significant number of the client's existing worksite employees in a long-term, non-project-related employment relationship, according to Clark. By comparison, a leasing or staffing service supplies new workers on a temporary or project-specific basis.

While professional employee organizations have grown tremendously, both PEOs and their clients need to be careful in the formalities of structuring such relationships and in their operation, she said.

MacDonnell agreed. Large corporations have the financial resources and expertise to maintain familiarity and compliance with the already vast and growing array of federal, state and local employment-related laws and regulations, but few small and midsized businesses can afford to do so, she noted. "PEOs offer small and medium-sized businesses a solution to this dilemma by providing them with the services and expertise of a large, experienced personnel department."

WHOSE EMPLOYEE IS IT?

The complications with PEOs arise from the different possible arrangements when a firm is interposed between a worker and a client company. Depending on how the contract is structured and the arrangement interpreted, the worker can be an employee of both the PEO and the client company; an employee of the firm and an independent contractor of the company; an independent contractor of the firm and an employee of the client; or an independent contractor of both the firm and the client.

And that's not all, cautioned MacDonnell, since one arrangement can fall under different categories for the purposes of different laws. "For example, a worker may qualify as an independent contractor of both the firm and the client company for federal employment-tax purposes, but qualify as an independent contractor of the firm and an employee of the client company for employee-benefits purposes," she said.

A problem with some PEOs in the past has been improper capitalization, MacDonnell indicated. "There have been a number of organizations that purported to be PEOs, but tended to behave akin to a Ponzi scheme," she said. "X company PEO goes out of business and creates Y PEO and doesn't remit X's taxes. It's a small group, but it has been very vigorously pursued by the IRS."

"Independent contractor issues generally come out of a state audit, in which case the IRS may get involved almost on an automated basis because of a change in determining the wage base," she said.

"If the state reclassifies independent contractors as employees, they say the wage base is now x plus y, so the company owes more employment taxes. These issues gestate at the state level and get to the IRS at an automated level, rather than an intentional audit. Audits also arise where the IRS is examining a corporate return for other issues and calls additional experts to look at the outside labor issue, or where an individual who provided services as an independent contractor decides he was not an independent contractor - often on the advice of his tax preparer - and asks for a Form SS-8 ruling," said MacDonnell.

"In an SS-8 ruling, the IRS looks at information submitted by the worker and the employer, and makes a determination. These are done at a fairly low level, and employers often don't understand the questions, so there has been a disproportionate number of rulings resulting in a reclassification from independent contractor to employee," she said. "The IRS will send out the ruling and instructions about how to refile the return and issue the W-2, and for years that was the end of it. But beginning last year they started sending follow-up letters to the employer, and there is anecdotal evidence that they are using these as audit leads."

MacDonnell noted that Section 530 of the Revenue Act of 1978, which was never incorporated into the Tax Code, provides the employer with a safe harbor. Thus, it protects the company against the IRS, requiring it to reclassify workers as independent contractors so long as the company has been consistent in treating the class of workers as independent contractors, has complied with Form 1099 reporting requirements, and has a reasonable basis for treating the worker as an independent contractor.

However, she cautioned, it only protects the employer, and not the employee. If a worker were determined to be an employee of a business under the common law test, but the business is protected under Section 530, the business would not be liable for federal employment taxes, but the worker would be liable for his share of FICA taxes. If he were an independent contractor under the common law test, he would be liable for the full amount of FICA taxes.

MacDonnell sees a role for accountants and lawyers in counseling clients on how to set up a business relationship, as well as how to respond to inquiries. "We work a lot with accounting firms, which by nature are dedicated to doing accurate reporting and being numerically correct," she said. "Accountants and attorneys can't get involved too early in employment tax issues, because it's a very technical area and the consequence of missteps can be far-reaching."

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