by Matt Dedon
The following article follows up on a previous post regarding changes to existing laws surrounding contractors under CA Senate Bill 459.
Previously, we explored the effects of the new California law that was enacted by Senate Bill 459. The new law provides steep penalties for those who willfully misclassify employees as independent contractors. In this blog entry, we will examine how the new California law is different from existing federal law.
Who Governs Employment Taxes Under Federal Law?
The IRS governs employment taxes under federal law. The laws are spread across the Internal Revenue Code and are codified in the Code of Federal Regulations.
How Do I Know if I am an Employee or an Independent Contractor Under Federal Law?
In order to characterize a worker as an independent contractor or employee, the IRS, until very recently used a twenty factor test. However, the IRS has since condensed the twenty factors into eleven. The full publication setting out the factors for the test can be found at: IRS Publication 15-A, 2010. Excerpted below are the eleven factors. The eleven factors are subdivided among three categories, Behavioral Control, Financial Control, and Type of Relationship.
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of—
- Instructions the business gives the worker. An employee is generally subject to the business' instructions about when, where, and how to work.
- Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Facts that show whether the business has a right to control the business aspects of the worker's job include:
- The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees.
- The extent of the worker's investment. An employee usually has no investment in the work other than his or her own time. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else.
- The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
- How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. An independent contractor is usually paid by a flat fee for the job.
- The extent to which the worker can realize a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An independent contractor can make a profit or loss.
Type of relationship
Facts that show the parties' type of relationship include:
- Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, the written contract can make a difference.
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. A true independent contractor will finance his or her own benefits out of the overall profits of the enterprise.
- The permanency of the relationship. If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company's regular business activity, it is more likely that the company will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Whether or not a person is an independent contractor depends on the facts of each case. However the general rule is that an individual is an independent contractor if the person for whom the services are performed has the right to control only the result of the work and not the means or methods used to accomplish the result.
What Are the Penalties For Misclassifying an Employee as An Independent Contractor?
If an employee is misclassified by his employer as an independent contractor, then the employer may be liable for withholding employment tax. The penalties for withholding the employment tax range from small civil fines to substantial fines and jail time. Overall, the penalties for violating federal law can be much worse than violating CA law.
If an employer’s federal employment tax deposit is less than five days late, there is a 2 percent fine.
- If an employer’s federal employment tax deposit is more than five days late but less than fifteen days late, there is a 5 percent fine.
- If an employer’s federal employment tax deposit is more than fifteen days late then there is a10 percent fine.
- For every month or partial month that an employer withholds federal employment taxes but then pays them late, the IRS imposes a penalty of 0.5 percent of the tax amount, up to a cap of 25 percent
- If an employer willfully attempts to evade federal employment taxes, then they have committed a felony. Such an employer may be fined $100,000. If the employer is a corporation then they may be fined $500,000. In addition to the fine, an employer may also face a prison sentence of up to five years.
- If an employer willfully fails to collect or pay to the IRS any federal employment tax, then they have committed a felony. The employer may be fined fined up to $10,000 and face a prison sentence of up to five years.
- If an employer willfully fails to file a return, keep federal employment tax records, or give the IRS information it requires, then they have committed a misdemeanor. They employer may be fined up to $100,000 for a corporation or $25,000 for an individual, and face a jail sentence of one year.
- If an employer makes a false statement to employees they may be fined $1,000 and face a jail sentence of one year.
Is There Any Exception That Can Protect an Employer?
Under federal law, an employer who has misclassified an employee as an independent contractor may find relief under section 530 of the Revenue Act of 1978. If an employer can meet the requirements for § 530, then they will not be liable for employment tax. Even better, they will not be liable in future years for employment tax if they continue to satisfy the substantive and reporting requirements. CA law has no such safe harbor.
To qualify for the safe harbor under § 530, the employer must meet three statutory tests. These are: reporting consistency, substantive consistency, and reasonable basis.
- The first test, reporting consistency, requires the employer to have treated the worker as being a non–employee. All federal tax forms and information reports must have been timely filed on a consistent basis
- The second test requires that the employer have consistently treated "similarly situated" workers as independent contractors. The taxpayer is also bound by any predecessor's filings, so if the taxpayer has acquired the business, the consistency requirement applies to both the taxpayer and the taxpayer's predecessor.
- Under the third test, the employer must have some reasonable basis for not treating the worker as an employee. § 530 contains 3 specific grounds to establish this reasonable basis, these are:
- The employer must have relied on a judicial precedent, technical advice memorandum (TAM) or published ruling.
- The employer relied on an IRS audit which characterized certain workers as independent contractors.
- The employer can demonstrate an industry–wide practice of treating categories of workers as independent contractors.
Still Have Questions? We can help.
The twists and turns of federal and state labor laws can be intimidating to a business owner. Employers should update and verify their independent contractor compliance under the California law and the existing federal laws. If you have any questions you can contact us at [email protected].
You understand and agree that use of this blog does not in any way create or establish an attorney-client relationship between you and any ARC Law Group attorney. You should recognize that the information provided on this blog is provided for your general information and should not be relied on as legal advice and is not a substitute for direct consultation with an attorney about a specific legal problem.