April/May 2019 Edition
The 2017 Tax Act ushered in a renewed focus on the proper classification of contractors as either employees or independent contractors. Over the last several decades, worker classification has been a concern for employers who engage independent contractors, due to the risk that the IRS might seek to reclassify the contractors to employees. If such a reclassification occurred, the employer may owe significant back taxes and would typically be required to treat such workers as employees going forward. The disparity in tax treatment between contractors and employees has been further heightened by the 2017 Tax Act, which created some new tax advantages for contractors over employees. Under the new tax law, an independent contractor is permitted to claim the new 20% qualified business deduction against its earned income, while employees are not permitted to claim the qualified business deduction against wages. Also, under the new tax law, employee business expenses are no longer deductible, yet independent contractors continue to be permitted to deduct their ordinary and necessary business expenses.
I. Worker Classification
Historically, the importance of determining whether a worker was an employee or independent contractor related to the difference in employer tax obligations. Wages of an employee are subject to withholding of income tax and FICA by the employer, and the employer has the additional obligation to pay the “employer portion” of the FICA and FUTA on the wages. Conversely, there is no employer withholding on the earnings of an independent contractor, nor is the company responsible for any FICA or FUTA with respect to the contractor’s compensation. Companies often view the independent contractor status for workers more favorably because of the tax savings as well as the avoidance of employee benefits. In certain industries, contractor status for workers is viewed as necessary by companies, since competitors are treating workers as contractors resulting in lower cost structures for a workforce and potentially a competitive advantage.
Conversely, the IRS has long disfavored contractor status because of the absence of income tax and employee FICA withholding on a contractor’s compensation, which, not surprisingly, has resulted in a higher amount of tax noncompliance among contractors compared to employees. For this reason, the IRS routinely conducts employment tax audits and examines whether workers who are classified as contractors should be reclassified as employees under applicable law. Regardless of how the company classifies its workers or classes of workers, whether as independent contractors, subcontractors, or otherwise, if the worker is more properly classified as an employee, the IRS may reclassify the worker as an employee.
Under applicable Treasury Department regulations, the relationship of employer and employee exists when the employer has the right to control and direct the worker, 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. The Treasury regulations also highlight the following criteria as relevant:
(i)whether the employer has the right to control the manner in which the worker performs the job; (ii) whether the employer has the right to discharge the worker (if so, this is an important factor indicating that the worker is an employee); and (iii) whether the employer furnishes tools and a place to work to perform the services.
The Treasury regulations, however, do acknowledge that if an employer’s right to control is limited to the result to be accomplished by the worker and not as to the means and methods for accomplishing the result, he is not an employee. Accordingly whether the company has control over the manner and method of performance is generally the ultimate question in determining worker status.
In order to better examine whether this control test is met, in 1987 the IRS issued further guidance that sets forth a list of the following twenty factors to be examined:
(1) instructions to worker;
(3) integration into business operations;
(4) requirement that services be rendered personally;
(5) hiring, supervising, and paying assistants;
(6) continuity of the relationship (permanency);
(7) setting the hours of work;
(8) requirement of full-time work;
(9) working on employer premises;
(10) setting the order or sequence of work;
(11) requiring oral or written reports;
(12) paying worker by the hour, week, or month;
(13) payment of worker’s business and/or traveling expenses;
(14) furnishing worker’s tools and materials;
(15) significant investment by worker;
(16) realization of profit or loss by worker;
(17) working for more than one business at a time;
(18) availability of worker’s services to the general public;
(19) firm’s right to discharge worker; and
(20) worker’s right to terminate relationship.
The IRS also directs that each of the twenty factors fall into three broad categories: behavioral control, financial control, and the relationship of the parties. The less control the employer exerts with respect to each of these three categories, the more the worker is to be considered an independent contractor rather than an employee.
Behavioral Control. Factors demonstrating behavioral control include instructions and training. Specifically, if the employer requires the worker to work full-time, or regulates the hours, location or sequence of work, this supports the characterization of the worker as an employee. Additionally, if the employer requires that the worker perform the services personally, controls the hiring and payment of assistants, and requires the worker to deliver oral or written reports on the work, this also supports the characterization of the worker as an employee.
Financial Control. Factors demonstrating financial control include how the worker’s compensation and business expenses are paid, and the provision of materials and tools to the worker. The IRS will also consider whether the worker has made a significant investment in materials and tools, and whether the worker has the opportunity to realize profits or losses, each of which factors support the characterization of the worker as an independent contractor.
Relationship of the Parties. The remaining factors demonstrate the relationship of the parties for purposes of determining whether a worker is an independent contractor or an employee. If the worker is an integral part of the operations of the business, this factor will weigh in favor of finding that the worker is an employee. However, if the worker’s services are available to the public or another company, this will weigh in favor of finding that the worker is an independent contractor. The IRS will also consider the firm’s right to discharge the worker and the worker’s ability to terminate the relationship as evidence of whether the worker is an employee or independent contractor.
Often companies attempted to document the contractor status of a worker or classes of workers by using Independent Contractor Agreements between the company and each worker. However, as mentioned above, merely labeling a worker as a contractor does not bind the IRS, which is free to examine the particular facts of the relationship to determine whether contractor status is proper.
There have been numerous judicial decisions that have wrestled with worker classification in the construction industry, with decisions coming down on each side. An example of a judicial decision in favor of contractor status is Illinois Tri-Seal Products, Inc. v. U.S., 173 Ct. Cl. 499 (1965), that held in favor of contractor for window installers status since no control existed between a window company and its installers. There, the installers were hired on a per job basis to install windows at the customer’s homes. The installers set their own hours and performed the work at the customer’s home without supervision by the company. The Court explained that,
All work was done away from plaintiffs’ premises and plaintiffs never attempted to control or direct the manner in which the installers did the work. Plaintiffs had no foremen or supervisors to direct the installers in the manner of doing the work and other than instructions contained in the worksheets – which the installers were expected to follow so that the work would be accomplished in accordance with the specifications contained therein – plaintiffs gave no directions or instructions to the installers concerning the manner or method of accomplishing the work. The installers called the plaintiffs for suggestions when unusual problems arose but this would not seem of particular significance… ‘An employer has a right to exercise such control over an independent contractor as is necessary to secure the performance of the contract according to its terms, in order to accomplish the results contemplated by the parties in making the contract, without thereby creating such contractor an employee.’ (Citation omitted). Illinois Tri-Seal at 520.
The Court determined that “[t]he factors here in their totality establish that plaintiffs did not have the right under the arrangement to control the manner and method in which the installers performed the work. They also establish that ‘plaintiffs’ only concern was that the [installers] accomplish a result in conformity with the terms of the contract with the owner of the structure to which the [material] was being applied.’” (Citation omitted). Id. at 522. In other words, the Court found that there is no control where the company’s oversight is limited to ensuring that the contract with the customer is fulfilled.
In instances where it is difficult to establish the nature of the relationship between the parties, their own view of their relationship can be determinative. In Illinois Tri-Seal, the Court of Claims held that,
the parties believed that they were creating a principal-independent contractor relationship and not an employer-employee relationship. The installers considered that they had their own business and that they were self-employed; they paid self-employment taxes; some had their own business cards; they carried personal and property liability insurance and were required to deposit with plaintiffs a certificate showing they had such coverage before being given any installation work. Plaintiffs did not carry any workmen’s compensation policy covering installers; did not pay State unemployment insurance on the earnings of installers; and did not withhold income taxes or assume liability for unemployment taxes on installers’ earnings.
The Court explained that, “in close cases, such as these, the view of their own relationship which is taken and acted upon by the parties – particularly with respect to the payment of employment taxes – is very significant.” Id. at 502.
Subcontractors working under general contractors are commonly characterized as independent contractors due to the nature of the construction industry. In Kurio v. U.S., 281 F. Supp. 252 (1968), the Court determined that subcontractors who provided painting work, hung drywall and hauled materials to and from job sites were independent contractors rather than employees of the general contractor. The Court explained that,
This is the procedure followed by Kurio: he would take the responsibility for the final product, but delegated the actual work, in very distinct parts, to subcontractors. Kurio looked only to the end result, and was not concerned with the details or means by which the result was accomplished… Each job was of comparatively short duration, and when a job was completed, the workers were free to accept a new job with another contractor – including one who might be in competition with Kurio. Permanency of relationship did not exist. Furthermore, if plaintiff were dissatisfied with the work of one of his subcontractors, he simply did not offer him another job. This is not the equivalent of the right to hire or fire, but merely is evidence of the right not to enter into a contract. (Citation omitted). Kurio at 261.
The Court in Kurio concluded that, “there is no support whatever either in fact or law for the position taken by the Government that the drywall workers, haulers or painters were Kurio’s employees.” Id. at 262. (See also Private Letter Ruling 9413001 (1993) (holding that “rig” welders hired as subcontractors by a general contractor are independent contractors); Tristate Developers, Inc. v. U.S., 212 Ct. Cl. 486 (1977) (holding that roofing and siding applicators hired by a home remodeling company are independent contractors); and Rayhill v. U.S., 176 Ct. Cl. 112 (1966) (holding that roofing and siding applicators hired by a home improvement company are independent contractors)). See also, Private Letter Ruling 8821022 (1988) (following the reasoning in the Kurio decision, the IRS determined that subcontractors engaged by a painting contractor were independent contractors).
II. Qualified Business Deduction.
Effective January 1, 2017 through December 31, 2025, the maximum federal income tax rate for individuals was lowered to 37%. The 2017 Tax Act also provides for the new qualified business income deduction (QBID), which generally entitles the business owner to a deduction equal to 20% of the net business income. There are limitations on the allowance of the QBID (for example, there may be limitations if certain wages or investment in asset thresholds are not met). Assuming the QBID applies, the maximum effective federal income tax rate on business flow-through income to the owner is approximately 30% [37% – (37% x 20%)]. Sole proprietorships, and owners of partnerships and S corporations are entitled to claim the QBID against their business income. Contractors engaged in the construction industry should be entitled to claim the QBID, subject to its limitations.
Conversely, employees are not permitted to claim the QBID against wages. Again, the Treasury regulations expressly provide that merely labeling a worker a “contractor” has no bearing on whether the worker is more properly treated as an employee. Accordingly, the worker classification issues discussed above is equally applicable to whether a contractor can claim a QBID. In other words, if the contractor is reclassified as an employee, the worker would not be entitled to the QBID.
Where a contractor is organized as an S corporation, there may be significant limitations on the tax benefit rising from QBID due to the general requirement that the owner of the S corporation be paid “reasonable compensation” as an employee of the S corporation to the extent of the value of the services furnished by the owner to the corporation. In cases where the owner is the sole employee of the S corporation, most, if not all of the gross receipts of the S corporation may be attributable to the services rendered by the owner. In which case, it is arguable that all of the net income arising from the S corporation should be paid as wages to the owner-employee. In this case, the QBID would have little value to the S corporation owner.
On the other hand, a contractor that is organized as an LLC that does not make an S election would be treated as a sole proprietorship if it is owned by one person, or a partnership if it is owned by two or more owners. In either case the owner(s) would more likely to be entitled to the full tax benefit of the QBID since owners are generally not permitted to be paid wages as employees from a sole proprietorship or a partnership. As a result, the owner’s entire cash flow from the business should be treated as net income (and not wages) and eligible for the QBID. For this reason, a contractor that is organized as an S corporation may want to consider reorganizing as an LLC that does not make an S election.
For existing employees who want to take advantage of the QBID by converting to independent contractor status the Treasury regulations have imposed a significant impediment. If the contractor simply continues to provide substantially the same services to the employer, or an affiliate of the employer, the Treasury regulations provide that the worker will be presumed to provide such service as an employee for the next three years. However, if the conversion to contractor status is accompanied by a substantial change in the employer’s control over the manner in which such services are performed (thereby justifying contractor status), contractor status may be permitted immediately (without a three year waiting period).
III. Employee Business Expenses. Unreimbursed employee expenses are no longer deductible on schedule A as a miscellaneous deduction for tax years 2018 through 2025. The limitation on the deductibility of unreimbursed business expenses does not apply to sole proprietors or partners in a partnership, such as a contractor that is organized as an LLC that is not taxed as an S corporation. Accordingly, for contractors who are engaged by a company as employees and who incur unreimbursed expenses, such as travel, the purchase of tools, work clothing and other costs, they would not be able to deduct such unreimbursed expenses against their wages. On the other hand, if the contractor is not an employee, those same expenses would presumably be deductible to the extent that they are reasonably related to the contractor’s business of performing services.
IV. Conclusion. Both companies and contractors may want to re-examine their current relationship to determine whether the current worker status is proper under applicable law or whether there is significant risk of IRS audit and tax exposure due to a misclassification. Contractors that are currently employees may want to consider whether they can convert to contractor status through the use of an LLC to perform services, and whether contractor status is supported under current applicable law. Redefining the relationship through consideration of the 20 factor test set forth by the IRS and documenting the rights and obligations of the parties through an Independent Contract Agreement make go a long way to supporting independent contractor status. For independent contractors that are performing services through an S corporation, the owner may want to reconsider the use of an LLC that does not make an S election in light of the exclusion of wages from the QBID.