Now is the Time to Review Payments for Contract Labor

October 2, 2009

When it comes to worker classification, a medical practice can reduce payroll taxes and minimize fringe benefit costs by using independent contractors versus hiring them as employees. The IRS and your state unemployment tax office on the other hand prefer that a business classify all of its workers as employees so that the employer is responsible for withholding income and payroll taxes. Often there is a thin line as to the correct status. So with year-end approaching, now is a good time to review payments you have made that are classified as contract labor or contract services.

A Method to Look at Worker Classification

While determining whether a worker is an employee or independent contractor sounds easy enough, even a simple application quickly shows this is not the case. There are three component rules (common law control rules, statutory worker occupation rules, and section 530 rules) that govern the worker classification process and each one must be considered and then applied for purposes of each federal payroll tax statute—federal income tax withholding (FITW), federal social security taxes and Medicare (FICA), and federal unemployment taxes (FUTA). The following four-step approach to worker classification is suggested:

Step 1. Test for Statutory Nonemployee Occupations . Under all three federal payroll tax statutes, qualified real estate agents and direct sellers are statutory nonemployees without exception. If the worker falls into either of these two occupations, no further testing is necessary. The worker is an independent contractor—end of story.

Step 2. Assess Possible Section 530 Relief . Even though an individual is classified as an employee for some or all payroll tax purposes, he or she may still be deemed an independent contractor for employment tax purposes under this rather narrow statutory provision created by Congress in 1978. It generally overrides both the statutory employee occupations and the common law control rules. A worker does not have to be a common law employee for Section 530 relief to apply. Therefore, Section 530 relief can be applied before the statutory employee (Step 4) and common law (Step 3) criteria. In fact, the IRS’s Employment Tax Handbook (a section of the Internal Revenue Manual) instructs IRS agents to apply Section 530 first.

To qualify for Section 530 relief, the employer must satisfy three conditions.

A. Substantive Consistency. In general, the medical practice must not have treated the worker, or any worker in a similar job position, as an employee during any prior tax year.

B. Reporting Consistency. The medical practice must have filed all federal tax returns and information returns, including Form 1099, for the year consistent with its treatment of the worker as an independent contractor.

C. Reasonable Basis. The medical practice must have a reasonable basis for treating the worker as an independent contractor using available safe harbors.

Step 3. Apply the Common Law Control Rules. Under the common law control rules, a worker is an employee if the employer retains the right to control both what must be done and how it must be done. A worker who is an employee under the common law control rules is treated as such for purposes of all three payroll statutes unless Section 530 relief applies. (See Step 2.) (In this instance, the statutory employee definitions listed in Step 4 do not apply since, by statute, a common law employee cannot be a statutory employee.) However, a worker who is an independent contractor under the common law control rules may nonetheless be treated as a statutory employee.

Step 4. Test for Statutory Employee Occupations. Each payroll tax statute classifies certain occupations as employees irrespective of their status as independent contractors under the common law control rules. Only a handful of statutory employee occupations exist.

A. FITW—compensated corporate officers.

B. FICA—compensated corporate officers, agent (or commission) drivers, full-time traveling salespersons, full-time life insurance salespersons, and home workers.

C. FUTA—same as FICA, except excludes full-time life insurance salespersons and home workers.

In some instances, a worker may be classified as a statutory employee for one or two, but not all, of the payroll tax statutes.

The four-step approach to worker classification focuses on the components that drive the process, not on specific payroll tax statute applications. The idea is to integrate the applications underlying all three federal payroll tax statutes into a single unified approach.

Making the Case for Independent Contractor Status

Independent contractor relationships should be closely monitored to ensure they can withstand IRS scrutiny. You can save clients considerable headaches and add significant value by helping them implement some strategies to strengthen their independent contractor relationships.

Conduct a Self-audit. One simple yet effective technique is to do a worker classification self-audit for each questionable worker. This self-audit should include:

1. Completing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) or similar questionnaire for workers whose status is questionable.

Be Careful: Employers should realize Form SS-8 requests critical information that could expose the medical practice to an audit. Furthermore, Form SS-8 is biased toward an employee-classification result. Moreover, the Treasury Inspector General for Tax Administration has stated in a recent report that the IRS’s inadequate oversight of the SS-8 program and the decentralized nature of the program may be resulting in inconsistent worker status determinations and, ultimately, inequitable treatment of taxpayers. Few businesses will actually want to file this form with the IRS. However, a review of the form can help the employer understand the criteria the IRS considers.

2. Reviewing independent contractor agreements and vendor files containing documentation supporting contractor status.

3. Determining if the company meets the Section 530 relief test.

4. Reviewing new developments affecting worker status. This is particularly important where the medical practice relies upon Section 530 relief and uses standard industry practice to meet the reasonable basis safe harbor.

Maintain Independent Contractor Agreements. A well-drafted independent contractor agreement supports the practice’s position and serves as a blueprint of the working relationship between the business and the independent contractor. The agreement should include those common law factors that support the classification of the worker as an independent contractor. In addition, the written contract should specifically mention that the worker will not be treated as an employee for federal tax purposes. A well-drafted agreement utilizes words like manager and contract instead of supervisor and hire, and payments are referred to as contract or service fees rather than wages, pay rates, or benefits.

Written contracts that reflect the actual business arrangement and are put in place at the beginning of the relationship (instead of years later when the IRS questions the arrangement), provide contemporaneous documentation of the parties’ intent to create an independent contractor relationship, and can help refute an IRS argument that the contracts are merely self-serving.

Conduct Transactions at Arm’s-length. Practical realities sometimes force the practice to lease equipment, advance funds, provide insurance coverage, or furnish bonding to the independent contractor. When these activities occur, the practice can help preserve the worker’s independence by:

1. Documenting the agreement in writing using normal business terms.

2. Requiring the independent contractor to submit bids in competition with other vendors.

3. Charging the independent contractor an arm’s length, fair market rate for the benefit provided.

4. Receiving the payment by check, rather than deducting it from the contractor’s bill. Sometimes, however, the hiring company cannot rely on the contractor’s funds, and the business must offset the amount due. If this offset occurs more than occasionally, the IRS may challenge the independence of the relationship.

Maintain Appropriate Documentation. It’s important for the business to document the evidence supporting the classification of larger independent contractors. In addition, the business should set up and maintain vendor files separate from payroll files. The vendor filing system should contain more than purchase orders and check copies. It should include documentation and evidence supporting the contractor’s nonemployee status such as bids, contracts, public advertisements, business cards and stationery, proof of reimbursements, and licenses and permits. The vendor file should also include Form W-9 and Form 1099-MISC, backup withholding documentation, and certificates of business and workers’ compensation insurance.

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