In the 1984 movie Gremlins, we learned that bad things happen when the cuddly Mogwai get wet, are fed after midnight and are exposed to bright light. Unfortunately, gremlins aren’t always confined to their movies and when they run amuck in the real world, they like to take on different forms. For example, terrible misfortune can also occur when an entity’s independent contractor agreements are exposed to the “bright light” of IRS scrutiny. Unfortunately, school districts may find themselves at a greater risk because of their regular use of independent contractors.
With Contractor Agreements, Come Much Responsibility
To be clear, there is no precise definition or guidance in the Internal Revenue Code with regard to the status of an employee versus an independent contractor. This fact has naturally resulted in a long history of litigation between the IRS and taxpayers. So, what’s at stake?
The employer of someone who is mischaracterized as a contractor could be faced with the specter of late payment and filing penalties – not to mention interest for failure to timely withhold and remit required payroll and trust-fund taxes (Social Security/Medicare) for/from these individuals. These penalties max out at 25 percent of the unpaid tax due with that return. However, since payroll returns are due on a quarterly basis; you could end up with multiple penalties across any given year. (And that doesn’t even touch the host of other employee benefits that should have been offered to the worker but weren’t.)
Because of the lack of formal guidance, courts have weighed in with their opinion of the characteristics generally associated with employer/employee relationships. Additionally, the IRS has also issued informal guidance on the factors it considers to be relevant to the determination of a worker’s status. This guidance is known as the “20 Factor Test.”
How To Spot An Employee
The summary the 20 Factor test includes a list of factors the IRS will use to evaluate the right to control the worker’s activities and the validity of the independent contractor classification. That being said, it’s important to note that the 20 factors are not equally weighted. For example, meeting 11 factors out of the 20 does not automatically create employer-employee relationship. Instead, the facts and circumstance of each situation must be evaluated against each of the factors in order to render a final decision.
The 20 factor test can generally be distilled down into three broad categories: Behavioral Control, Financial Control and the Type of Relationship the parties intended to create.
- Behavioral Control Factors examine whether the district has the right to direct the worker in the performance of their duties and control how the work is to be done. Employees, for example, are typically given instructions on when and where to work and are provided with the required tools needed to perform their duties.
- Financial Control Factors determine the ability and extent to which the worker can realize a profit or incur a loss. Consideration is also made with regard to any facility or equipment investments that were made by the worker to complete a job as well as the existence of any unreimbursed business expenses.
- Type of Relationship Factors consider any written contracts and the description of the relationship they intend to create as well as the worker’s ability to perform the same service for other businesses, the permanency of the relationship and whether any type of “employee” benefits are provided to the worker.
Using these categories as guidelines, a worker will likely be classified as an employee when they are told when and where to perform their duties, given the tools to perform their job and are restricted from being able to perform similar services for others regardless of whether the documents state they are acting as independent contractors.
If you are uncertain as to whether your independent contractors should actually be classified as employees, remove all doubt and submit your inquiry to the IRS via Form SS-8. The agency will review the facts and will soon thereafter issue a determination. Once granted, and as long as all facts remain the same, all parties will be bound to the IRS’s determination. Email Rea & Associates for additional assistance.
By Christopher Axene, CPA (Dublin office)