Tax Reform: A Reason to Revisit Employee/Contractor Classifications
The race to the finish line on tax reform ran at an unprecedented pace. From the time a first draft of this article was written, through to publication, government officials scrambled to determine what the racetrack roughly looked like. However, it is still somewhat to be determined what twists and turns are yet to occur, and who the winners and losers will be.
Hidden in these changes is the potential for many current “employees” to seek a change in relationship with their “employers” to more closely resemble a business relationship instead of an employment relationship. This article is intended to provide a brief overview of the steps you can take now to plan for an increase in discussions of this possibility.
Pass-Through Taxation—What Does it Mean?
Historically, income earned by pass-through entities—sole proprietorships, partnerships, limited liability companies (that had elected partnership tax treatment), and S-corporations—was passed through to the owners, who then paid income tax based on the individual income tax brackets that applied to their income levels.
Generally speaking, a major goal in pushing for tax reform was to lower the maximum effective tax rate for pass-through income. And, with the recently-passed bill, it seems that this goal was greatly achieved. To call any such adjustment to the pass-through tax rules a “reduction” would be over-simplifying, but for many pass-through entities, this will most definitely be the case.
Under the passed bill, a pass-through entity will continue to pass its income through to its owners. However, some pass-through owners will now receive a 20% deduction against a portion of their business income. As a result, many pass-through business owners will achieve significant tax savings, simply by virtue of their income being taxed via a pass-through entity instead of as employment wages or earnings.
Will This Affect Employee, Vendor Relationships?
With that backdrop, if we operate under the assumption that at least some pass-through entities will achieve greater tax savings, this would seem to create an incentive for employees to seek a change in their relationships with employers. If instead of being an employee of the company, a worker could form a sole proprietorship and successfully position it as a business partner/vendor of the company, she could well see a significant reduction in the amount of tax she pays.
Now, this isn’t to say that employees will be seeking this treatment with ill will and an intent to “pull one over” on the U.S. government. Tax reform may simply be the catalyst for many current employees to re-evaluate their positions, and many such individuals may be more properly classified as independent contractors. Nonetheless, it will be important for you to think through your classifications of employees and contractors and have a systematic process in place for determining any new changes to such classifications.
Please Make My Paycheck out to John Smith, LLC
So, what happens if a current employee leaves the company, forms her own separate business entity, and seeks a business contract to become a vendor instead? Do you have to do anything?
When it comes to classifying a relationship with a business entity (and not an individual), there are two competing tax concepts. The first is that, generally speaking, a properly formed business entity should be respected in most instances for tax purposes. However, in the employer-employee classification context, courts have found that an employee of a properly formed, separate business entity may ultimately be considered an employee of the labor-recipient entity if facts exist to suggest that this is more proper than considering the individual an employee of her own legal entity. As such, even an individual providing labor through a separate business should be reviewed to properly document that she isn’t (or, possibly, is) an employee of the company.
The distinction between employees and independent contractors has been long discussed, and several different tests exist for making this classification, depending on the context for review. However, following the June 2017 withdrawal of the U.S. Department of Labor’s (DOL) administrative interpretation that had taken the position that “most workers” were employees rather than independent contractors, it remains unclear what position the current DOL will take regarding employee classification.
This article focuses on the IRS multifactor test, which stems from the common-law definition of an “employee” and is generally the most broad-reaching test applicable to employee/independent contractor classifications.
IRS Multifactor Test
The heart of the IRS multifactor test looks at the employer’s “right to direct and control” the worker. This right to direct and control is broken into three main subcategories, which the IRS describes as a series of facts and circumstances, with no “magic number” of total controlling factors.
What follows is an overview of the questions you should answer and document for classifying employees and independent contractors. Each of the categories and questions below should be reviewed for each worker or category of workers performing identical tasks.
No. 1: Behavioral Control
Instructions. What control do you have over how a worker completes his task? Do you have the ability to control when and where he performs the work, what tools he uses, or where he purchases supplies or services? Do you control what workers may assist him or who should perform a specific task? Who decides what routine or pattern to follow or in what order or sequence tasks must be performed?
In addition, do you provide detailed instructions to the worker about processes? If the worker doesn’t follow your instructions, what recourse do you have?
Training. Do you provide periodic or ongoing training about business procedures that are to be followed? Note, the IRS training manual indicates that this type of training strongly suggests an employer-employee relationship but specifically instructs its agents to “disregard orientation or information sessions” that cover generic business policies, product lines, etc.
The worker’s skill and work type should also be considered. The IRS training manual lists “highly trained professionals such as doctors, accountants, lawyers, engineers, or computer specialists” as individuals that may require very little training or instruction on performing their services and therefore may lean toward nonemployee status.
No. 2: Financial Control
Significant investment. Does the worker have a significant investment in the facilities or equipment she uses? The common example in this category is truck drivers who either have purchased their own trucks or use company trucks.
Unreimbursed expenses. Does the worker incur unreimbursed business expenses? While both employees and independent contractors may receive reimbursement for expenses, the IRS training manual explains that unreimbursed business expenses tend to carry more weight in making this determination. It includes the following as potential expenses to review: rent and utilities; tools and equipment; training; advertising; payments to business managers and agents; wages or salaries of assistants; licensing/certification/professional dues; insurance; postage and delivery; repairs and maintenance; supplies; travel; leasing of equipment; depreciation; and inventory or cost of goods sold.
Services available to the relevant market. Does the worker have the ability to seek out separate business opportunities, and does she exercise this ability? Keep in mind that if a contractor is under a long-term contract, she may not need to actively advertise and seek out opportunities, but the mere ability to take on additional work apart from you tends to suggest a contractor relationship.
Method of payment. Is the worker paid on an hourly, daily, weekly, or similar basis for the labor performed? If so, the IRS tends to weigh this significantly in favor of an employer-employee relationship. However, if a worker receives a flat fee for the task performed, this suggests a contractor relationship. Commission-based compensation requires additional review because this factor can weigh in either direction, depending on the surrounding circumstances.
Opportunity for profit and loss. After reviewing the above factors and anything else that may be relevant, does the worker have an opportunity to realize either a profit or a loss from the task performed? Does she have an influence on items such as inventory quantities, the decision to purchase or lease equipment, or make monetary or capital investments, which may have a direct impact on her bottom line?
The overall opportunity for either profit or loss from a given project tends to suggest the relationship of an independent contractor. Employees rarely risk realizing a loss, regardless of your profitability from a given task or business venture.
No. 3: Relationship Between Worker and Firm
Intent of the parties and contractual relationship. How is the relationship between the parties described in any contract and/or other written agreement? This question, while of course not conclusive, can show the intent regarding the worker and has been described as “very significant in close cases.”
Employee benefits. Is the worker provided with employee benefits, such as paid vacation or sick time, health insurance, retirement or pension plans, or life or disability insurance? Note that for benefits provided under a tax-qualified retirement plan, 403(b) annuity, or cafeteria plan, only employees can be participants, so the IRS would likely view a worker’s participation in any such plan as conclusive evidence that she is an employee (although some courts have disagreed).
Discharge and termination. Is the relationship between you and the worker indefinite? Or is it ultimately temporary in nature, whether short- or long-term? Historically, this factor was viewed through the lens of whether the individual had the ability to terminate the relationship “at will,” or whether restrictions existed. Recently, however, the IRS has expressed an opinion that this factor alone “no longer constitutes persuasive evidence” because of the multitude of practical reasons that may prevent the termination of a relationship (for example, severance pay or “golden parachutes” owed on termination) or the lack of remedies for nonperformance of contractor services.
Regular business activity. Is the work performed an integral part of your regular business? Even if the work performed may be viewed as separate from your regular business, have the worker’s activities become so blended into your overall business as to be viewed as one operation? If the answer to either factor is yes, this tends to suggest an employee relationship.
Although the distinction between employees and independent contractors isn’t a new consideration, the passage of tax reform suggests that, to some extent, a broad range of taxpayers may begin to reevaluate their status as either employees or contractors of their current employers. Because the IRS has historically argued that employees of separate business entities may ultimately be considered employees—and not merely vendors—employers that blindly assume vendors are simply contractors run the risk of unknowingly misclassifying employees.
Take some time to ensure that a documented process is in place for classifying this type of relationship, and follow this process consistently with proper documentation on file for each such classification.
This article, slightly modified to note recent updates, was featured in the January 2018 issue of the Wisconsin Employment Law Letter, which is co-edited by Axley Brynelson Attorneys Saul Glazer and Michael Modl and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.