Classifying workers as either employees or independent contractors is important. The correct worker categorization has a profound impact on businesses because it affects not only how workers are paid, but how the government gets paid. Because of the latter reason, this is an issue that will not be going away any time soon. In fact, it’s been thrust into the forefront more than ever due to changing economies, technological revolutions and recent legislative actions.
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?
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.
And an important side note here — make sure you are appropriately inquiring of your clients if they are involved in the gig economy before you prepare their returns, perhaps asking if they “occasionally” drive for Uber or Lyft. If the answer is yes, make sure that receipts and other documentation are available for support.
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.
Your responsibilities as the adviser
As if the classification topic wasn’t complex enough, another very big aspect for CPAs to consider involves the ethics of advising clients about classifying workers. Keep in mind that the potential for unauthorized practice of law (UPL) if you are advising clients on worker classification and have not been licensed or admitted to practice law in a given jurisdiction. Check your state rules to find out where all these lie and what you can or cannot do regarding giving any advice.
Where can I learn more?
Check out these additional resources for more guidance:
AICPA webcast with Art Auerbach “Employee or Independent Contractor? A Guidebook to Proper Classification”. In this webcast, Art details the new Form 1099-NEC, categories of statutory employees and nonemployees, tax consultant issues and more. This webcast is available exclusively to Tax Section members.
Independent contractor or employee? Varying tests, The Tax Adviser, December 2019