Small business owners and self-employed individuals often need to deal with the complicated and often confusing issue of distinguishing between “employee” and “independent contractor” status. This issue is especially important to the growing number of individuals working from home. Usually the goal of the businessperson is to justify an independent contractor status while the IRS prefers to assert an employer/employee relationship for wage tax purposes. But you may wish to retain eligibility for certain employee benefit plans, even if you may be considered a contractor for wage tax purposes.
There are potentially serious consequences for making a mistake in this area. If the IRS reclassifies a worker as an employee, the employer may owe all of the retroactive wage taxes immediately – even those not collected from the worker! There may be additional interest and tax penalties. When a mistake is discovered in an employee benefit plan, the plan administrator may refuse to convey benefits to a worker who is not eligible for the benefit. This could be disastrous in the case of a business life insurance or health insurance plan. Since there are no absolute rules in this area of business management, it is always wise to consult with your own financial and tax adviser.
The rules used to determine status for wage tax purposes do not apply for eligibility in employee benefit plans. It is possible to be considered eligible for an employee benefit plan but actually be treated as a contractor for wage tax purposes. The opposite is also true – you may not be eligible for employee benefits but still be considered an employee for tax purposes. Determining eligibility for employee benefits is actually much easier – this is stated clearly in the written plan description for each individual employee benefit. Just be careful not to assume that the classification for one issue has any effect on the determination for another purpose.
If your goal is to make sure that a work arrangement is really a contractor relationship, the most effective thing you can do is to send a letter to your contractor which details the relationship and addresses each of the topics addressed below. Get the other party to acknowledge the letter and to hold a copy of the letter in their records as well. Best of all worlds is to have a written contract in which the topics in my letter would be incorporated. In either case, make sure you DO what you write.
These 20 factors are taken from IRS Revenue Ruling 87?41. There is no set number of factors that must be in your favor, so the idea is to get as much insurance as possible. We suggest that you meet 15 out of 20 of the factors in your favor to be “safe”.
1. Does the principal provide instructions to the worker about when, where, and how he or she is to perform the work?
2. Does the principal provide training to the worker?
3. Are the services provided by the worker integrated into the principal's business operations?
4. Must the services be rendered personally by the worker?
5. Does the principal hire, supervise and pay assistants to the worker?
6. Is there a continuing relationship between the principal and the worker?
7. Does the principal set the work hours and schedule?
8. Does the worker devote substantially full time to the business of the principal?
9. Is the work performed on the principal's premises?
10. Is the worker required to perform the services in an order or sequence set by the principal?
11. Is the worker required to submit oral or written reports to the principal?
12. Is the worker paid by the hour, week, or month?
13. Does the principal pay the business or traveling expenses of the worker?
14. Does the principal furnish significant tools, materials and equipment?
15. Does the worker have a significant investment in facilities?
16. Can the worker realize a profit or loss as a result of his or her services?
17. Does the worker provide services for more than one firm at a time?
18. Does the worker make his or her services available to the general public?
19. Does the principal have the right to discharge the worker at will?
20. Can the worker terminate his or her relationship with the principal any time he or she wishes without incurring liability to the principal?
If you cannot easily meet the standards of this 20-point test, don’t worry yet. There is another “safe harbor” provision added to the tax law a few years ago. If you can show that a substantial portion of your industry uses sub-contractors in the same status as your particular position, then you are safe in considering yourself also as a sub-contractor. The difficulty in relying on this safe harbor test is that you need to be reactive to your industry and the IRS, rather than be pro-active in designing your business relationships for the effect that you desire.
About the Author
Tony Novak, MBA, MT is a writer and financial adviser in Narberth, PA focusing on tax and employee benefit issues. His businesses www.MedSave.com and Freedom Benefits Association provide online benefits enrollment for thousands of individuals and businesses nationwide.