70 West Madison St.
Chicago, Illinois 60602
Are Your "Independent
Contractors" Really Employees?
Independent contractors who are
engaged by an employer for an extended period of time may be treated
as employees for tax and benefits purposes. Whether these workers
are freelance creatives or employees obtained through a temporary
employment agency, if they render services for a single employer at
the employer’s place of business under its direct supervision,
they will probably be employees, not independent contractors. This
conclusion will follow even if the "independent
contractor" has entered into an agreement with the employer or
the employment agency providing that the individual is not an
employee. Under these circumstances, the Internal Revenue Service
would very likely determine on audit that such workers are
"common law employees."
The consequences to the employer of
reclassifying independent contractors as common law employees
1. The employer will be
responsible for one-half of the Social Security taxes payable
with respect to the employee’s "wages." This tax is
in two components, and the employer’s portion for old age,
survivors and disability insurance is 6.2% of compensation up to
the annual wage base. The employer’s share of hospital
insurance (medicare) is 1.45% of all wages paid.
2. The employer will be
responsible for Federal unemployment tax with respect to wages
paid to the employee.
3. The employer will be
responsible for any failure to deduct income tax withholding
from the employee’s compensation. Retroactive assessment of
this liability may be mitigated if the employee has properly
reported the income for tax purposes.
4. The employer may be liable for
any benefits payable to "employees" that were denied
to the reclassified employee while he was treated as an
independent contractor. These benefits would include retirement
plan participation and any group health benefits. Particularly
on a retroactive basis, these liabilities can be substantial.
The possible responses to a situation
in which an employer has "independent contractors" who are
really employees include the following:
(a) Reclassify the workers in
question as employees for purposes of internal payroll and
benefits as well as tax reporting. This will entail, among
other things, the reporting of worker compensation on IRS Form
W-2 rather than IRS Form 1099. Also negotiate a reduction in
cash compensation to pay for benefits, if appropriate. This
approach will not affect any liability for past conduct, but
should eliminate the employer’s exposure for future taxes
(b) Enter into specific
agreements that make it clear that the "independent
contractor" intends to be treated as an independent
contractor for all purposes. This document would include an
acknowledgment that the worker has voluntarily elected to
forego certain employee benefits and assurances that the
worker will properly discharge his tax liabilities as an
independent contractor. The agreement should also contain an
indemnity running to the employer to protect it from the
liabilities enumerated above, to the extent possible. Note
that these agreements will not influence the outcome of an IRS
audit except possibly in borderline cases. Also, because of
the substantial dollar amounts of potential employer
liability, the indemnity agreements, even if enforced by a
court, may not provide reliable protection.
(c) Make sure the benefit plans
which exclude the independent contractors very clearly provide
that the exclusion will apply even if the workers are
reclassified as employees. For example, a profit sharing plan
could, within the limits of the coverage rules, be amended to
expressly exclude from coverage any independent contractor who
has been reclassified as a common law employee. This approach
can help isolate the benefit exposure from the tax exposure.
(d) Invoke the IRS
administrative procedure for arriving at a settlement of back
tax liabilities. Although this approach may result in a better
settlement than an audit, a voluntary settlement with the IRS
will eliminate the chance of avoiding liability entirely by
playing "audit roulette" (that is, doing nothing in
hopes that the applicable limitations period expires before
there is an IRS audit).
Golan Christie Taglia LLP
70 West Madison St.
Chicago, Illinois 60602