By Stephen J. Dunn
A company operates a maid service that cleans residences. The company has always treated its maids as independent contractors rather than employees. The company has not withheld any taxes on the workers, and has reported their earnings to the Internal Revenue Service on Forms 1099 rather than Forms W-2. The company has not provided health, dental, or vision insurance to the workers, or allowed them to participate in its retirement plans.
A worker who had not received an assignment in a while filed a claim for unemployment compensation from the company. The state unemployment insurance agency sustained the claim. The company is contesting the claim before an administrative law judge. If the company is unsuccessful before the administrative law judge, it can further contest the claim in court. If the claim is ultimately sustained, the company will owe unemployment insurance contributions on all of its cleaners for the open years of the statute of limitations (generally, two-four years, depending on the state).
Worker Reclassification—What’s at Stake
If the company’s workers are classified as employees for any purpose, this can be used against the company in reclassifying the workers as employees for other purposes (this is called “preclusion”). Thus, reclassifying the workers as employees for unemployment insurance purposes can have a domino effect, leading to reclassification of the workers as employees for purposes of—
• State workers compensation coverage
• Federal unemployment tax
• Federal employment tax (Social Security tax, Medicare tax, federal income tax withholding)
• State income tax withholding
• Subjecting the employer to civil liability for wrongfully discharging the employee; and entitling the employee to participate in the employer’s employee benefit plans, such as those providing health, dental, and vision insurance, and retirement plans
• Subjecting the employer to minimum wage laws, and laws requiring payment of time and a half for overtime, with respect to the workers
The employer’s liability under each of the above laws goes back through the open period of the applicable statute of limitations. The company would also face liability for civil penalties for failing to report and deposit the subject taxes.
Where an employer has consistently treated workers as independent contractors for employment tax purposes, and there has been a reasonable basis for such treatment, then, under Section 530 of the Revenue Act of 1978, reclassification of the workers as employees for purposes of federal employment taxes shall only have prospective effect. A taxpayer is treated as having a reasonable basis for not treating an individual as an employee for a period if the taxpayer’s treatment of such individual for such period was in reasonable reliance on any of the following:
(A) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;
(B) a past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or
(C) long-standing recognized practice of a significant segment of the industry in which such individual was engaged.
The burden of proof in tax controversies is usually upon the taxpayer. But where—
(i) a taxpayer establishes a prima facie case that it was reasonable not to treat an individual as an employee for purposes of Section 530 of the Revenue Act of 1978, and
(ii) the taxpayer has fully cooperated with reasonable requests from the IRS,
then the burden of proof with respect to such treatment is upon the IRS.
“Employment tax” for purposes of Section 530 of the Revenue Act of 1978 includes federal income tax withholding, Social Security tax, Medicare tax, and federal unemployment tax.
There is no comparable safe harbor from reclassification under laws other than federal employment tax laws.
Who Is an Employee?
The relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so.
The right to discharge is also an important factor indicating that the person possessing that right is an employer.
Providing a place for workers to work is a telltale indicator of an employer. Where workers work at home, the company can still be held to be their employer by providing them with a computer, internet access, telephone service, furniture, supplies, etc. Even if the workers are on the road, the company can be held to provide a place for them to work by specifying a route or territory for them.
Specifying hours or days for workers to work is another indicator of an employer.
The existence of a contract specifying that workers are not employees but independent contractors is not always determinative. Courts and administrative bodies tend to look to the substance of the relationship. This is especially true in the federal context. Contracts are creatures of state law. Under the United States Constitution, federal law is the supreme law of the land.
Classifying workers as other than employees is a dicey proposition. Where they are retroactively reclassified as employees, their employer is retroactively liable for federal and state income tax, Social Security tax, and Medicare tax that should have been withheld from their wages, but it cannot recover those taxes from the employees, many of whom are no longer in its employ. Where there is uncertainty about whether workers are employees, the company is well-advised to treat them as employees, and build the cost of doing so into its pricing structure.