Employee or contractor? Classification matters.

By Art Auerbach, CPA, CGMA

Classifying workers as either employees or independent contractors is important. The correct worker categorization has a profound impact on businesses because it affects not only how workers are paid, but how the government gets paid. Because of the latter reason, this is an issue that will not be going away any time soon. In fact, it’s been thrust into the forefront more than ever due to changing economic environment, technological revolutions, and recent legislative and administrative actions. This can also affect the calculations of Section 199A, the amount of Paycheck Protection Program (PPP) loans received, and the amount of the PPP loans that are forgiven. Classification also has a profound effect on the calculation of the various employment credits (retention, family leave and sick pay).

What’s the difference between the classifications? Why does it matter?

The IRS has long had a voice in the categorization discussion.

In 1987, based on an examination of cases and rulings, the IRS developed a list of 20 factors to consider when determining whether a worker should be classified as an employee or independent contractor. The IRS’s next steps included the identification of three categories of evidence that may be relevant in the determination in “Independent Contractor (Self-Employed) or Employee?”

1. Behavioral control — Is there a written agreement between the parties? Who controls what the worker does and how the worker does his or her job? Is it the company or the individual? The pandemic has complicated this decision with many working remotely.
2. Financial control — Who provides the tools and supplies? Who controls how the worker is paid? Can the worker perform work for other businesses? Who provides the materials? Where is the work to be performed? (This brings the nexus decisions into the mix, as to where the individual files a return or seeks approval of a business [licensing]. Paying licensing fees and local taxes is very important.)
3. Other factors — Is the worker entitled to benefits (i.e., pension plan, insurance, vacation pay, etc.)? Who is to perform the services? Can assistants be engaged? If so, with approval? How was the worker counted when determining full-time employees for the PPP loan process or the employee retention credit?

But why does this matter? In a nutshell, employees receive a Form W-2, Wage and Tax Statement, and are taxed on this income at the federal and state levels. Employers must withhold these income taxes from employee paychecks and remit them to the IRS on the employee’s behalf. These aren’t the only taxes that are withheld, though. Employers must also withhold Social Security and Medicare taxes (together known as the Federal Insurance Contributions Act [FICA] taxes). The FICA tax is 15.3%, and the employer and employee each pay 7.65%. Then, there is the Federal Unemployment Tax Act (FUTA) tax. Only the employer pays FUTA tax; it is not deducted from the employee's wages. The FUTA tax rate is 6%, but it could be higher as a result of pandemic choices.

Those treated as independent contractors have received Form 1099-MISC is the past and will receive Form 1099-NEC for amounts paid in excess of $600 beginning with the year 2021.

It’s easy to understand why businesses, from a financial perspective, might prefer workers classified as independent contractors: they wouldn’t have to withhold income tax and would not be liable for employer share of the FICA taxes and 100% of FUTA taxes for the worker (state unemployment tax is also an issue complicated by nexus), and the reduction in benefit expenses is an added bonus.

To help with the classification, firms and workers can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. Workers file Form SS-8 and a formal determination is sent to both the payer and worker and will be binding with the IRS. This form has been the same for years and is not reflective of the current economy. State decisions are a separate matter.

In addition, this determination affects the calculation of the Section 199A deduction and if the taxpayer obtained a PPP loan, the calculation of the amount of the loan forgiven, and the amount of the loan. Remember that 60% of the PPP loan must be spent for payroll and related payroll expenses.

Changing economies don’t fit the mold

The traditional factors used to assess worker classification do not translate easily in today’s economy given how businesses are changing their models to offer different services to customers. For example, do you still get into your car, drive to the grocery store, shop, check out and drive home? Or do you download your favorite grocery store’s app, add your items to your virtual shopping cart, press the “submit button,” and wait a few hours for those groceries to arrive on your doorstep? Is the worker who shopped and delivered the items to you an employee of your favorite grocery store? Or is he or she an independent contractor? Traditional classification criteria might not result in the perfect answer.

A new gig for the gig economy

The gig economy is expanding rapidly as internet platforms are used more to connect service providers to customers. The gig economy generally includes industries in which workers complete tasks on an on-demand or client-by-client basis, such as Uber and Lyft drivers or restaurant home-delivery services. The emerging gig economy has raised questions about how to classify workers for tax purposes.

An important side note here — make sure you are appropriately inquiring of your individual clients if they are involved in the gig economy before you prepare their returns, perhaps asking if they “occasionally” drive for Uber or Lyft. If the answer is yes, make sure that receipts and other documentation are available for support. For the business clients, inquire if they have filed the appropriate Forms 1099.

Legislation at play

Many states use some form of an “ABC test” to aid businesses in the classification of a worker. This is an ever-changing environment. California has a notable adoption of an ABC test that garnered mainstream attention in the state’s Supreme Court ruling in April 2018 in the case of Dynamex Operations West, Inc., v. Superior Court. The ruling established that companies must use a three-pronged test to determine how to classify workers. This test assumes that workers are employees unless the company that hires them can prove otherwise.

In September 2019, California legislatively followed up on the decision with the passage of Assembly Bill 5 (AB-5), popularly known as the “gig worker bill.” Effective Jan. 1, 2020, the law requires companies that hire independent contractors to reclassify those workers as employees, with a few exceptions.

Many states have started to pattern themselves after California, and we may see in the upcoming year many state legislatures engaged in renewed or new discussions regarding the gig economy.

In its spring term, the U.S. Supreme Court refused to hear the case of New Hampshire v. Massachusetts, a squabble between those states over nonresident income tax — effectively leaving nexus up to the individual states.

In related federal news, on Jan. 9, 2020, the IRS released IR-2020-04 and announced the launch of a new GIG Economy Tax Center to help people involved in the gig economy area meet their tax obligations.

Your responsibilities as the adviser

As if the classification topic wasn’t complex enough, another very big aspect for CPAs to consider involves the ethics of advising clients about classifying workers. Keep in mind that the potential for unauthorized practice of law (UPL) if you are advising clients on worker classification and have not been licensed or admitted to practice law in a given jurisdiction. Check your state rules to find out where all these situations occur and what you can or cannot do regarding giving any advice.

Arthur Auerbach, CPA, CGMA, is an independent tax consultant located in Atlanta, Ga., specializing in tax consulting and estate and financial planning for individuals and closely held businesses. He is affiliated with the Asbury Law Firm as a consultant. Arthur is a member of the VSCPA Tax Committee and a former member of the AICPA’s Tax Executive Committee. He is currently chair of the Georgia Society Federal/State Task Force and a member of AICPA’s Tax Practice and Procedure Committee.