Employee or contractor: Who decides?

With the economy taking baby steps towards recovery and the year end approaching, businesses are planning for their staffing needs in 2013. Hearing talk of the fiscal cliff and other uncertain economic indicators, a company may consider engaging an independent contractor instead of hiring an employee. Is it really as simple as that?

The issue of whether a worker is an independent contractor or an employee has been around a long time. The IRS and taxpayers have frequently disagreed on the proper classification of workers. The IRS wants more employees for a variety of reasons, starting with the ability to use employers as extensions of the government for collection of payroll taxes and the generation of increased tax revenue on a consistent year-round basis. Companies frequently prefer independent contractor status to avoid the withholding, payment of taxes and the burden of reporting all of this to the government. In addition, the company may avoid having to pay workers' compensation insurance and providing benefits to a non-employee.

Who decides? Whether a person is an independent contractor or an employee is not strictly a matter of choice. Even if both the employer and the worker agree on a classification, that is not good enough. According to the IRS and the courts it is a matter of facts and circumstances. They have issued guidance sometimes called the "20-factor test" to help employers make correct classifications. You can find a list of these factors in Revenue Ruling 87-41, and the IRS Web site has a great deal of information on this topic also.

The IRS interest in this issue is not a secret: The agency announced several years ago that it would be actively auditing business tax returns for what they call worker misclassification. It's easy to see why. Each time the IRS is successful in classifying an independent contractor as an employee, they generate additional revenue from payroll taxes, penalties and interest for the year under audit and all years not closed under the statute of limitations.

What will the IRS look at? In the Internal Revenue Manual, the IRS instructs its audit personnel to focus on three areas of inquiry: they are to look for evidence of behavioral control, financial control and the relationship between the payer and the worker. While each of these could be the subject of a separate article a brief synopsis is provided below:

Behavioral control: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Here's an example courtesy of the IRS: A plumber agrees to install plumbing in a new warehouse being built. Upon arriving at the warehouse, the plumber is given the building plans showing where the plumbing is to be installed, and advised that the plumbing must be completed within five days. This is direction of what is to be done, rather than how it is to be done, and is consistent with independent contractor status.

Financial control: Does the worker or the company control the business aspects of the worker's activities? Who invests in equipment and supplies? Who stands to make a profit or loss from the worker's activities? Does the worker seek out business opportunities to benefit themselves or the company?

Consider this example: A company engages Bill to perform landscaping services on its grounds. The services include weekly lawn mowing and hedge trimming. Bill advertises these services in the Yellow Pages, on his Web site and Facebook page and is available to provide landscaping services to others. Bill is exercising financial control over his activities.

Relationship of parties: How do the company and the worker perceive their relationship? Is there a written contract that documents the intention for the worker to be an employee or independent contractor? Does the worker receive employee benefits? Is the worker providing a key service to the company?

Here's an example: A bakery famous for its cinnamon rolls engages a baker. The baker signs a contract agreeing to only use the secret recipe for the cinnamon rolls, to the quantities and times outlined by the bakery. The baker provides key services to the bakery and the bakery has the right to control the baker because the baker's success determines the success of the bakery. This would indicate an employer-employee relationship.

In a perfect world all business owners would be knowledgeable about the worker misclassification issue and take proactive steps to document their intentions regarding the classification of a worker and act with the level of control appropriate with that designation. In the real world, the facts and circumstances of how a company interacts with each worker may not jive with how they classify the worker. It is very likely there will be some factors that point to employee status and some that point to independent contractor status. The IRS acknowledges this and admits there is no magic formula or objective test. The IRS advises the auditor in these cases to weigh the evidence looking at the relationship as a whole and determine whether the evidence of control or autonomy predominates.

Getting back to the original question of "Who Decides?", the company deciding about staffing for 2013 may want to bring on independent contractors because it makes the most economical sense. The IRS can challenge that decision and will win or lose depending on the facts and circumstances. Factors such as an uncertain economy will not win the day if other factors show the worker is subject to the will of the company not only as to what will be done but how it will be done.

Susan Van Plew is a certified public accountant and a senior manager with Kafoury, Armstrong & Co. Contact her at 775-689-9100 or visit www.kafoury.com.