Independent Contractor or Employee?

A Critical Decision for Businesses

The consequences of misclassifying workers can be costly. If you misclassify an employee as an independent contractor, for example, you may be liable for back taxes (including the employee’s shares of unpaid payroll and income taxes), plus penalties and interest. As discussed below, there may be serious nontax consequences as well.

Why does it matter?

Businesses must withhold federal and state income taxes, Social Security taxes, and Medicare taxes from the wages they pay employees and deposit those taxes with the IRS or state tax authorities. They are also required to pay the employer’s portion of Social Security and Medicare taxes, and to pay federal and state unemployment taxes. Generally, none of these obligations apply to independent contractors.

What happens if you misclassify an employee as an independent contractor? Not only will you be liable for the employer’s portion of payroll taxes that you should have paid (plus penalties and interest), but you also may be on the hook for the employee’s portion of income and payroll taxes.

There may be significant nontax consequences as well. For example, when classified as an employee, the worker may be entitled to minimum wages and other employee benefits. You may also need to furnish workers’ compensation insurance and make state disability insurance contributions.

How do you decide?

To decide whether workers are employees or independent contractors for federal tax purposes, familiarize yourself with the factors the IRS considers in making that determination. Many of these factors go to the degree of control the business exerts over the worker and the degree of independence the worker enjoys. No single factor is determinative, so it is important to weigh all of them.

The IRS examines factors in three categories:

1. Behavioral Control
   Does the company control or have the right to control what the worker does and how the worker does it? Generally, the more control the company has, the more likely a worker is an employee. Relevant factors include the extent to which the company provides instruction and training.
2. Financial Control
   Does the company control the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies? A worker is more likely to be considered an independent contractor if, for example, they have an opportunity for profit or loss, makes their services available to other businesses or is paid a flat fee rather than an hourly wage.
3. Relationship of the Parties
   Workers are more likely employees if the company provides them with employee benefits, they are hired indefinitely (rather than for a specific time period or project) and they provide services that are a key aspect of the business.

Note that entering a contract with a worker that designates them an independent contractor does not make it so. However, it may be a relevant piece of evidence in determining the parties’ relationship.

Important: Many businesses mistakenly believe that all remote workers are independent contractors. The ability to work remotely may demonstrate a worker’s independence, but a remote worker may still be considered an employee if the business controls the details of the work that is done and how it is performed.

Gaining peace of mind

Classifying workers as independent contractors can generate significant cost savings, but given the potentially harsh consequences of misclassification, it is critical to have a reasonable basis for your classification. If you do, and you meet certain other requirements, you may be entitled to relief from penalties and from having to pay the worker’s employment taxes.

What can you do if, after weighing the factors, you are still uncertain whether a worker or group of workers are employees or independent contractors? Ask your tax advisor to explain the rules in more detail, based on their experience working with companies in similar situations, to help you make an informed decision.

Beyond federal taxes

Even if you are comfortable with your classification of workers for federal tax purposes, it is important to consider their treatment for other purposes, such as state taxation and federal and state wage and hour regulations. Treating workers as employees for some purposes and independent contractors for others can pose a significant administrative burden, so examine their status for all purposes before making your final decision.

Sidebar: DOL issues new independent contractor rule

Different jurisdictions and agencies may apply different principles in determining a worker’s status. For example, the U.S. Department of Labor (DOL) recently issued a final rule updating its guidance and rescinding its previous employer-friendly rule in favor of a six-factor test.

Although the DOL considers many of the same factors as the IRS, its inquiry focuses on whether, as a matter of “economic reality,” a worker is “economically dependent on an employer.” As explained in the DOL’s Small Entity Compliance Guide, courts have interpreted the economic reality test to be broader than the control test applied by the IRS. As a result, “some workers who may be classified as independent contractors for tax purposes may be employees for (purposes of the Fair Labor and Standards Act).”

Warning to Investors: Beware the Wash Sale Rule When Harvesting Losses

For investors, a popular year-end tax planning strategy is to “harvest” investment losses. This strategy allows you to offset investment gains plus up to $3,000 in wages or other ordinary income ($1,500 if you use married filing separately status).

However, if you plan to repurchase the same, or a substantially identical, security after selling an investment at a loss, watch out for the “wash sale” rule. If you violate this rule, you will lose the ability to deduct your losses.

What is loss harvesting?

Suppose you sold a few investments earlier this year and ended up with a net capital gain. If you own some investments that have declined in value, you might consider selling them at a loss to offset the gain and reduce your tax bill. This strategy is known as “harvesting” tax losses.

After harvesting a loss for tax purposes, you may want to repurchase the same investment. Perhaps you believe that the investment has great potential to rebound in the future, or maybe it has sentimental value. That is where the wash sale rule comes into play.

What is the wash sale rule?

If you sell an investment to generate a tax loss and then quickly repurchase the same investment, the IRS views the tax loss as “manufactured.” The wash sale rule is designed to avoid this perceived abuse of the tax law by disallowing a loss if you buy a “substantially identical” security within 30 days before or after you sell a security at a loss.

For example, let’s say you purchase 100 shares of a stock for $100 per share. The stock’s value plummets to only $50 per share, so you sell it, generating a $5,000 capital loss. Three weeks later, the stock’s price declines even further to $40, and you purchase 100 shares for $4,000. The second purchase violates the wash sale rule, so you are not permitted to claim the $5,000 loss.

What happens to the disallowed loss?

When you sell an investment for less than you paid for it, you have experienced a real economic loss, so disallowing that loss for tax purposes may seem unfair. However, the wash sale rule does not permanently deprive you of the ability to claim the loss; it merely defers it.

When a loss is disallowed under the rule, that loss is added to your tax basis in the replacement securities, reducing your taxable gain (or increasing your deductible loss) when you sell it.

How can you avoid the wash sale rule?

There are a few ways to avoid the consequences of the wash sale rule. The simplest is to wait at least 31 days before you buy the security again. Bear in mind, though, that there is a risk that the price will have increased by then, erasing some or all of the tax benefits.

Another option is to “double up” on your investment — that is, buy the same number of shares of the identical investment and then wait at least 31 days before selling the original investment. If the price is still less than what you paid for the original investment, you can deduct the loss while keeping the investment in your portfolio. If the price goes up, you will enjoy additional gains.

Yet another option is to replace the original investment with one that is similar, but not identical (such as stock in a similar company in the same industry). One strategy that will not work is to have a related party, such as your spouse or a corporation you control, buy the same security within 30 days before or after you sell it. The wash sale applies to such transactions as if you and your spouse (or your controlled corporation) are a single person.

Harvest with care

Harvesting investment losses can be a great way to lower your tax bill. If you take advantage of this strategy, pay close attention to your investments for the next 30 days to be sure you do not run afoul of the wash sale rule. Contact your financial advisor for more details.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.