Worker classification has been a point of contention with the Internal Revenue Service (IRS) for decades. After all, organizations that use the services of independent contractors save significant money on federal employment taxes, so it’s in the agency’s best interest to ensure these classifications are accurate. Over the past several months, however, the need to ensure appropriate worker classification has increased. Organizations of all industries are being scrutinized as never before, as federal and state agencies are ramping up their enforcement efforts. What does this mean for your government agency?
A worker may be properly classified as either an employee or as an independent contractor, based on the facts and circumstances surrounding the relationship. An employee is an individual who performs services for an organization and is subject to the organization's control regarding what will be done and how it will be done. An independent contractor is an individual who performs services for an organization, but the organization only controls the result of the work.
The IRS considers three categories of evidence when determining whether a worker is an employee or independent contractor: behavioral control, financial control, and the type of relationship. With behavioral control, the type and degree of instructions given to the worker by the organization need to be evaluated as well as any training provided by the organization. Also, the way in which the organization evaluates the worker’s performance can have an impact on the classification. The key fact to consider is whether the organization retains the right to control the worker regardless of whether that organization actually exercises that right.
There are several questions to ask when evaluating the financial control. Is the worker free to seek opportunities to perform the services elsewhere in the market? Does the worker assume the risk of profit and loss? Is the worker paid by the hour or by the job? Is the worker responsible for making a significant investment in tools and supplies? Does the worker incur unreimbursed business expenses?
In evaluating the type of relationship between the organization and the worker, key information to consider is the permanency of the relationship, whether employee-type benefits are provided to the worker, and whether the services provided represent the key activity of the organization.
You Have Options
There are options available for organizations that may have potentially misclassified workers. One option to consider is whether IRS Section 530 Relief applies. Section 530 Relief refers to a section of the Revenue Act of 1978 under which organizations will not owe employment taxes for misclassified workers if certain requirements are met. First, the organization has to have a reasonable basis for treating the workers as independent contractors. Reasonable basis can include judicial precedent, prior audit results, or a long-standing industry practice. In addition, the organization must show that it has treated all workers doing similar work consistently and that all required federal tax returns (Form 1099) must have been filed.
Another option is the Voluntary Classification Settlement Program (VCSP). Organizations can apply for the VCSP in order to properly classify workers for future tax periods. Organizations would be subject to pay 10 percent of the prior year tax on the favorable rates with no interest or penalty charges. There are several eligibility requirements for the VCSP. For example, the organization must currently be treating workers as nonemployees, it must be filing 1099s for all nonemployees, and the organization cannot be currently under audit.
Treatment of Election Workers
In governmental organizations, a common misclassification typically occurs with election workers. Compensation paid to election workers is not subject to income tax withholding under Section 3401(a) of the Internal Revenue Code. However, treatment of FICA taxes depends upon the existence and stipulations in a governmental entity's Section 218 agreement1. If an employer has a Section 218 Agreement that covers services performed by an election worker, that agreement will stipulate whether the payments to election workers are subject to FICA.
If there is no Section 218 agreement, for calendar year 2012, FICA taxes apply to an election worker whose wages are $1,500 or greater. When payments made to a worker meet the current $1,500 threshold, all payments paid to the worker are subject to FICA, including the first $1,499. A W-2 must be filed for election workers who receive payments of $600 of more, even if no FICA and income tax were withheld. A W-2 must also be filed for each election worker who received payments of less than $600 that are subject to FICA taxes under a Section 218 Agreement.
Penalties for failing to classify workers appropriately are steep. The IRS can order offenders to pay all employment taxes that should have been paid, plus penalties and interest based on a percentage of the tax bill. The amount of the payment, including penalties and interest, can vary significantly depending upon whether the organization has consistently reported similar workers and filed all required returns timely.
If you are unsure of the proper classification of a worker, you can refer to Revenue Ruling 87-41, in which the IRS has provided guidelines that include twenty factors used to determine whether sufficient control exists to create an employer-employee relationship. In addition, Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be used as a self-audit tool. Please consult your advisor before submitting an SS-8 to the IRS for an official determination. For more information, contact your Plante Moran engagement team member.
1A Section 218 Agreement is a written voluntary agreement between a State and the Social Security Administration to provide Social Security and Medicare Hospital Insurance (HI) or Medicare coverage only for employees of State and local governments. This agreement is authorized under Section 218 of the Social Security Act. Employees covered under a Section 218 Agreement have the same coverage and benefit rights as employees in the private sector. All States have a Section 218 Agreement, but the extent of coverage varies.
When the Social Security Act (Act) was enacted in 1935, State and local government employees were excluded from Social Security coverage because there was a legal question regarding the Federal government’s authority to tax State and local governments.
Because many governmental employees did not have their own retirement system, the 1950 Social Security Amendments added Section 218 to the Act to make Social Security coverage for State and local government employees possible.