Proper Classification of Workers: Employee or Independent Contractor?

The importance of properly classifying workers as either an employee or independent contractor has once again been brought the spotlight with an important case out of California. People v. Uber Technologies, Inc., et al highlights the battle between state authorities and ride-sharing services which both offer up dissenting opinions between worker classification. Since worker classification can vary between states let’s focus on how this issue would have been viewed had it arisen during an IRS examination.

The IRS relies on a common law test which is a twenty-point test to determine the classification of a worker. Under these rules, workers are considered employees if an employer has the right to direct and control workers in the manner in which they work, specifically in the details of when, where, and how their work is done. It is important to note that no single factor is decisive as all facts and circumstances must be considered when making such distinctions.  Below is a list of the twenty factors which would be applied during an IRS examination, with the first three factors being the most crucial:

1. Level of instruction
2. Amount of training
3. Realization of profit or loss
4. Degree of business integration
5. Extent of personal service
6. Control of assistants
7. Continuity of relationship
8. Flexibility of schedule
9. Demands for full-time work
10. Need for on-site services
11. Sequence of work
12. Requirements for reports
13. Method of payment
14. Payment of business or travel expenses
15. Provision of tools and materials
16. Investment in facilities
17. Work for multiple companies
18. Availability to public
19. Control over-discharge
20. Right of termination

Upon application of the above twenty-point test, a determination is made and certain action items by the employer are required. When a worker is classified as an employee the employer is required to collect and remit payroll taxes to the IRS and state jurisdictions where applicable. A Form W-2 is provided to the employee which reports the amount of wages paid. Conversely, if the worker is classified as an independent contractor, the employer is not responsible for payroll tax obligations and is only required to file a Form 1099 to report the amount of wages paid.

Misclassification of workers is a costly issue. Upon losing this issue during an IRS examination significant tax penalties based upon the contractors’ wages for the last three years can be levied against the employer. However, the costs do not end at the Federal level as state jurisdictions will also piggy-back on the IRS examination results and pursue back payments of unemployment insurance, workers’ compensation premiums, and any other state-specific fines that can be levied. An example of state-level costs was recently memorialized in New Jersey on January 20, 2020, when Governor Murphy signed into law a series of bills that result in fines for employers that misclassify workers as independent contractors starting at $250 for a first violation and up to $1,000 for each additional violation. Additionally, the State reserves the right to levy an additional fine up to 5% of the misclassified worker’s gross earnings.

To make matters confusing even though a worker is properly classified as an independent contractor for Federal tax purposes, the same worker may be classified as an employee for state reporting requirements. So, in the case of People v. Uber Technologies, Inc., et al. even though California won, and Uber & Lyft must reclassify their workers as employees² it is possible that the Federal review of the facts may result in a different result.

As always, due to the costly nature of worker misclassification, we recommend consulting with your WG tax advisor before classifying workers as independent contractors.

²Due to the passage of Proposition 22 Uber & Lyft no longer need to classify their workers as employees