The evolving saga of “employee vs contractor”, from the small business employer’s perspective, means that you should revisit the conversation for business planning purposes now.
In case you’ve been so engrossed with other headlines that you haven’t read any business news: the world of independent contractors, so-called “gig workers” is facing rapid and dramatic change. This post, like most of my content, is produced from the small business’ perspective. If you are a worker, then there are other better sources of advice on this topic.
In the way of background information on wage taxes, Kelly Phillips Erb covered the topic well in this Forbes article last summer. The situation from the individual’s perspective is covered in Marketwatch here.
Recent news this past month includes developments in California’s AB5, New Jersey’s ABC Test, Uber, Lyft. Change will continue through the year ahead.
In general, the trend of the past was to structure casual labor as an independent contractor arrangement and to structure taxes the same way (think Uber, for example). That is changing. In the future the governments will treat the payments for this work this as employee compensation for tax reporting purposes even if you legally set up the work arrangement as independent contractor for other common law purposes (like setting your own hours and working without supervision).
The legal distinctions and ‘changeover process’ will be defined by evolving laws, mostly at the state level. That mean that it won’t happen everywhere at the same time. See this for links to state laws. For small businesses, any change in tax law like this takes years for implementation and compliance. Realize that this issue, like all tax law changes, is a highly politicized process. Change is likely to happen in more progressive coastal states first.
Federal tax law is relatively stable on this issue but IRS complicates the matter by using five classifications:
– independent contractor
– employee (common-law employee)
– statutory employee
– statutory nonemployee
– government worker
When discussing the issue, I tend to use examples that highlight sensitive real-life issues rather than rely on the standard advice published by tax authorities. Examples of some of these real-life factors that would weigh in favor of treating the tax accounting of labor payments an independent contractor for tax reporting purposes would be: 1) they are in a different business than you (they are in the sales consulting business, while you are in computer repair business, for example), 2) they have separate business licenses issued to office locations other than yours, 3) Only a relatively small portion of their income in sales comes from you, 4) they have public advertising, business cards, social medial pages or printed brochures marketing their services in such a way that you know they are in business for themselves separately from working for you, and 5) the payments are made to a business entity, for example “John Smith LLC” rather than an individual and the entity pays the individual a salary. So while these are not the only determining factors, they illustrate the point.
The best advice is: handle taxes for labor payments as employee compensation even if you call them independent contractors for other purposes unless your tax matters representative (the person who will represent you in the event of wage tax audit, presumably your CPA) has documented and supported your decision, in advance, to treat them as independent contractors for tax reporting purposes. My 2020 small business and nonprofit work engagements include a provision for “advance compliance with ___ (cite pending state law)” that addressed this changing situation.
One final thought: taxes stand “as reported” if you are not audited. In other words, it is what you say it is. If you say the payment is independent contractor compensation, then that’s what it is on your tax filings. Federal law is clear (Robert P. Groetzinger, 59 AFTR 2d 87-532 Supreme Court 1987) on how your gig worker must report this income on their tax return, yet not all workers follow this rule. Worker noncompliance increases employer risk.
IRS ‘fans the flames’, so to speak, with its advice to workers: “Workers who believe they have been improperly classified as independent contractors by an employer can use Form 8919, Uncollected Social Security and Medicare Tax on Wages to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation”. When this happens, it is bad news for the employer.
If this employee vs. contractor situation is audited and changed by a federal or state revenue agent then you have relatively little chance of successfully fighting their determination. These audit results are typically expensive for the employer but it is usually better to settle rather than fight.
The risk starts with employers who don’t seek clear information, think they can get away with their own worker determinations, or unfortunately, occasionally tax professionals who are not well informed on the issues. A CPA experienced in labor law should easily be competent to offer workable advice to avoid any worker classification problems.
Your biggest risk of audit and reclassification might be when an ex-contractor (or their lawyer) reports to government that the worker should have been covered by workers compensation or employee benefits (unemployment compensation, DI, or social security). In that case you are probably screwed if you reported the payments as independent contractor compensation. (Again, think about Uber’s recent 180 degree turn on the issue where they were likely going to lose).
What I can do
An accurate determination of worker classification begins with a discussion of your business model, an assessment of legal and industry trends that apply to you. The discussion leads to the development of clear workable guidelines regarding worker classification in your company. I’d be happy to have that business planning conversation.