How to distinguish between employees and independent contractors
by Tony Novak, CPA, MBA, MT
revised 8/28/2014
Distinguishing between employees vs. independent contractors for purposes of the various tax, government, entitlement and insurance purposes can be complex and frustrating for small business owners. The financial and legal consequences of making an error in properly identifying an “eligible employee” vs. “independent contractor” can be severe. A number of tax program, social entitlement programs, employee benefits and insurance programs are designed exclusively for “eligible employees”. But how does an employer determine who is an employee? The answer varies depending on which tax provision, benefit plan, or other program under consideration. Many business owners are surprised to learn that a person who is not an employee for one type of program or wage tax is often considered an employee under another definition.
The following table is designed to point out some differences:
| For purposes of: | Who is an eligible employee? | Possible consequences for incorrect classification |
| Federal Income Tax/FICA | The IRS makes the determination based primarily on whether the employer directs the actions of the worker as explained here.1 An employer cannot elect to treat common law employees as contractors. If the employer has reasonable basis for classifying workers as independent contractors IRS Form SS-8 allows employers to avoid tax penalties. | Employer is responsible for all (both employer and employee’s portion) of wage taxes plus substantial penalties and interest. IRS does aggressively pursue violators. Any “responsible person” including a bookkeeper or employee may also be personally liable for severe violations. |
| Worker’s Compensation | Coverage is based on the business payroll records. Any person who receives pay for service who is not covered by worker’s compensation by another employer is considered a covered employee for worker’ s compensation unless a specific exemption applies. For example, owner/employees are exempted in most states. | Employer is responsible for payment of medical costs and lost wages for uncovered workers. |
| Health Insurance | Health insurance is always voluntary. Any person is eligible (whether employee, contractor, associate, partner, etc.) if working an average of 30 or more hours after the “waiting period” designated by the employer in the plan document. Owners are eligible for coverage but are not employees except in C corporations.2 | No coverage is offered for non-eligible persons if the intention was determined to be fraudulent during a claim investigation. The insurer may drop firms that are habitual offenders. Unintentional enrollment errors do not invalidate the insurance. |
| Sec. 125 Cafeteria Benefit Plan | Owners are not employees. Employees can be included or excluded by “class” as determined by the owner, as long as the determination does not discriminate in favor of highly paid individuals. The employer determines waiting period and employee matching. | If the plan’s eligibility determination is improper, then the entire firm’s plan benefits will be taxable for the year. If the plan benefits become discriminatory by accident during the plan year then only the excess benefits will be taxable to the highly paid person. |
| Simplified Employee Pension | All employees must be included who had more than $400 compensation including seasonal and part-time employees. Employees under age 25 or with less than 2 years of employment may be excluded. | All contributions for the year become taxable to each employee. |
| 401(k) Plan or other Qualified Profit Sharing Plan | Defined by the plan document. Employers have latitude is deciding who is included as an “eligible employee”. | Plan disqualification with adverse tax treatment is a possible risk, but most employers are allowed to correct any errors voluntarily when discovered without incurring tax penalties.3 |
| Private Pension and “Non-qualified” Profit Sharing Plans | Completely determined by the business owner. Discrimination is allowed. Subcontractors may participate. | No penalties. |
A key point illustrated in this chart is that an employee for one purpose or program definition is not necessarily an employee for another purpose or program definition.
Employers not in compliance may wish to consider the liberalized voluntary correction program offered by IRS. In December 2012 the Journal of Accountancy reported “the IRS made significant changes to its Voluntary Classification Settlement Program (VCSP). In Announcement 2012-46, in effect until June 30, 2013, the IRS is temporarily permitting employers who have not filed Forms 1099 for their workers to participate in the program by paying a larger amount of past due tax than would be due under the normal VCSP. In Announcement 2012-45, which modifies and supersedes Announcement 2011-64, the IRS says it is liberalizing a few of the program’s rules.
IRS updated the VCSP in the summer of 2014 and the new rules arenow available online. The most important thing to consider is that these liberal settlement terms are not available after IRS begins an employment tax audit so it is imperative that the employer take initiative before an audit begins.
Footnotes:
1 An earlier revision of this article removed reference to the “20 point test” established by IRS in Revenue Ruling 87-41 and the “3 additional factors” discussed by IRS in other publications because the IRS no longer refers to these tests in its own current publications. A taxpayer argument based on the 20 point test would not likely be sustainable now.
2The Affordable Care Act includes nondiscrimination rules for health insurance that don’t allow employers to offer better health insurance to executives and owners or exclude regular employees from coverage. The new rules about nondiscrimination in health plans have not yet been issued. The IRS will not enforce thos part of the new law until the mew regulations are issued.
3IRS estimates that over half of all 401(k) plans have technical problems that, if audited, could lead to plan disqualification. Fortunately audits are infrequent and most problems, once discovered, are addressed through voluntary compliance.
Related Video:
Watch the video: 1 minute 59 seconds
Resources:
Forbes article 8/27/2014: “FedEx Misclassified Drivers As Independent Contractors, Rules Ninth Circuit”
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