Beginning in November 2009, the Internal Revenue Service (IRS) will begin audits under its latest National Research Program (NRP). The IRS started the NRP in 2001 to measure the “tax gap.” The tax gap is the difference between taxes that are voluntarily reported, versus the taxes the IRS estimates are actually owed with full reporting. The IRS estimated that unemployment taxes are almost 20% of the suspected annual $345 billion tax gap.
To test the IRS’s estimates (as well a collect additional taxes in the process), the IRS will audit 6,000 U.S. companies to determine whether the tested businesses pay all their required employment taxes. These audits will provide data for its first statistical analysis since 1984. The audits will address the following four areas:
- Employee Classification – Have you properly classified workers as employees versus independent contractors, and therefore paid all related payroll taxes?
- Fringe benefits – Are you reporting taxable compensation for the personal use of business vehicles? Are you complying with discrimination and other standards that allow various non-taxable fringe benefits to avoid taxation, vs. reporting such items as taxable compensation?
- Officer compensation – Have you reported unreasonably low compensation paid by closely-held S corporations, or excessively high compensation paid by closely-held C corporations.
- Reimbursed expenses – Are reimbursements for properly- documented expenses? Are amounts being paid impermissible flat dollar or percentage allowances?
Although each of these areas is a frequent area of abuse, particularly for smaller businesses, employee classification is suspected to be the largest.
Testing whether a worker is an independent contractor
This summer, the IRS issued its “Summertime Tax Tip 2009-20” for business owners regarding the classification of employees vs. independent contractors. It provided the following summary-level advice:
“Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.
- Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
- Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
- The Type of Relationship factor relates to how the workers and the business owner perceive their relationship…
If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees. If you can direct or control only the result of the work done — and not the means and methods of accomplishing the result — then your workers are probably independent contractors.”
Additional guidance regarding whether a worker will be classified as an employee versus an independent contractor is contained in Revenue Ruling 87-41, which provides the following twenty factor test:
- Is the worker required to comply with instructions about when, where and how the work is done?
- Is the worker provided training that would enable him/her to perform a job in a particular method or manner?
- Are the services provided by the worker an integral part of the operations?
- Must the services be rendered personally?
- Does the business hire, supervise, or pay assistants to help the worker on the job?
- Is there a continuing relationship between the worker and the person for whom the services are performed?
- Does the recipient of the services set the work schedule?
- Is the worker required to devote his/her full time to the person he/she performs services for?
- Is the work performed at the place of business of the company or at specific places set by the company?
- Does the recipient of the services direct the sequence in which the work must be done?
- Are regular oral or written reports required to be submitted by the worker?
- Is the method of payment hourly, weekly, monthly (as opposed to commission or by the job?)
- Are business and/or traveling expenses reimbursed?
- Does the company furnish tools and materials used by the worker?
- Has the worker failed to invest in equipment or facilities used to provide the services?
- Does the arrangement put the person in a position of realizing either a profit or loss on the work?
- Does the worker perform services exclusively for the company rather than working for a number of companies at the same time?
- Does the worker in fact make his/her services regularly available to the general public?
- Is the worker subject to dismissal for reasons other than non-performance of the contract specifications?
- Can the worker terminate his/her relationship without incurring a liability for failure to complete the job?
A “yes” answer to any the above questions may mean the worker is an employee (except question 16, for which a no answer indicates that the worker may be an employee). Fortunately, no single answer is determinative, since practically all independent contractors will fail at least one of the tests.
In August 2009, the Government Accountability Office issued a report on the misclassification of employees. The report made six recommendations, generally directed at (i) increasing the Department of Labor’s and the IRS’s educational and audit emphasis in this area, and (ii) improving coordination of the federal and state agencies’ enforcement in this area. Even without the IRS’s MNP program, this area will be getting increased attention.
State Employment Issues and Litigation
Classification of a worker as an employee vs. and independent contractor also has importance regarding the applicability of state wage and hour laws. Alleged misclassification has created a number of class action lawsuits on behalf of workers. These lawsuits contend workers should receive additional pay and/or benefits based on the independent contractors being instead classified as employees. If successful, these cases generate substantial damages.
In a recent case, the employer refused to settle, and won its position at both the trial and appellate levels. The case involved a messenger service that converted their employee drivers to independent contractors. The jury determined that the drivers working under contractor agreements were properly classified as independent contractors. The class-action plaintiff appealed the jury’s verdict, arguing that the jury was improperly instructed as to the legal standards for analyzing whether a worker is an employee or an independent contractor.
In Cristler v. Express Messenger Systems, Inc., 2009 Cal. App. (Fourth Appellate District) the appellate court ruled that the instructions provided to the jury correctly stated the applicable legal principles. The jury instructions were as follows:
“In determining whether the Plaintiffs and other class members (“drivers”) were employees or independent contractors, you must consider a number of factors. You will need to weigh all of these factors based on the evidence that you have heard. The most important factor to consider is the extent to which the Defendant has the right to control the details of the work performed.The following additional factors are to be considered:
The right to discharge at will without cause;
Whether the drivers are engaged in a distinct occupation or business;
The skill required in this occupation;
Whether the driver or[the employer] pays for vehicles, equipment, and business expenses;
The length of time for which the services are to be performed;
The method of payment to drivers, whether by the hour or by the job;
Whether or not the work done by drivers is part of the regular business;
Whether or not the parties believe they are creating an employer-employee relationship;
The driver’s opportunity for entrepreneurial profit or loss depending upon his/her managerial skill;
The drivers’ use of helpers/replacements: and
The degree of permanence of the working relationship.
These individual factors cannot be applied mechanically as separate tests; they are intertwined and their weight depends often upon particular combinations.”
These tests usually require the assemblage of underlying data as a basis for then applying significant judgment. In light of employers’ risk under both tax and employment laws, companies and their legal advisors should proactively review this area. You should document the conclusions reached, which will then facilitate rapid rebuttal of allegations that are likely to be arising with increased regularity. Since compliance by other companies is this area is often weak, plaintiffs and government auditors will have plenty of other easy targets to move onto once your documentation is presented.