Tax Connections Newsletter – Winter 2022
Robert Swenson

Independent Contractor Versus Employee: Is Your Business Classifying Workers Properly?

The “gig economy” has affected nearly every industry and profession. From Uber to Instacart, new business models have sprouted in recent years that build upon workforces treated as independent contractors. And even traditional businesses have been relying more heavily on freelancers and other contract workers, a trend that has accelerated during the COVID-19 pandemic.

From a business’ perspective, there are several tax and other advantages of classifying workers as independent contractors rather than employees. However, it is important to remember that workers are not independent contractors simply because you say they are or because you and the workers have written agreements to that effect. The IRS and other government agencies look at all the facts and circumstances to determine whether workers are misclassified.

Related Read: Welcome to the Gig Economy! Now, Calculate Your Taxes

What are the advantages?

For tax purposes, companies that properly treat workers as independent contractors avoid several tax obligations that apply to employees. For example, a company generally is not required to withhold federal or state income taxes, pay the employer’s share of Social Security and Medicare (FICA) taxes, withhold the workers’ share of FICA taxes or pay federal or state unemployment taxes.

In addition, companies that use independent contractors may avoid several nontax obligations, including requirements to pay minimum wages and overtime under the federal Fair Labor Standards Act and similar state laws, furnish workers’ compensation insurance (in many states), make state disability insurance contributions, or provide employee benefits.

How is worker status determined?

To determine whether a worker is an employee or independent contractor, the IRS looks at several 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 performs his or her job? Generally, the more control, 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? Again, the more control, the more likely a worker is an employee. Relevant factors include:

    • The extent of a worker’s investment in items such as equipment and tools (a bigger investment tends to favor contractor status);
    • The extent to which the worker has unreimbursed business expenses (contractors tend to have a higher level of unreimbursed expenses);
    • A worker’s opportunity for profit or loss (the risk of incurring a loss generally indicates that a worker is a contractor);
    • Whether a worker makes services available to others (contractors are generally free to seek out other business opportunities in the relevant market); and
    • The method of payment (employees generally receive a guaranteed wage per hour, week or other time period; contractors are usually paid a flat fee — although some contractors are paid by the hour).
  3. Relationship of the Parties
    Workers are more likely employees if the company provides them with employee benefits, such as health or disability insurance, pension plans, paid vacation or sick days. The permanency of the relationship is also a significant factor: Employees are more likely to be hired indefinitely, while independent contractors are more likely to be engaged for a specific project or time period. Also, companies are more likely to use employees to provide services that are a key aspect of their business.

Related Read: Classifying Workers as Employees or Independent Contractors: When Bringing Back Workers, Follow the Rules

The terms of a contract that designates a worker as an independent contractor or employee are not controlling. However, they may be relevant in showing the parties’ intent to form a specific type of relationship.

IRS penalties for misclassification

The consequences of misclassifying employees as independent contractors can be severe. Among other things, the IRS may assess back taxes against the company (including employees’ shares of unpaid payroll and income taxes), plus penalties and interest.

Notably, the IRS can impose significant penalties on an employer, even if workers wrongly classified as independent contractors met all of their tax obligations. And do not overlook nontax implications. For example, a company that misclassifies workers as independent contractors may be liable for unpaid benefits, minimum wages, overtime pay or workers’ compensation premiums.

Related Read: Independent Contractor vs. Employee: Understanding Worker Designation

Review your hiring policies

Given the significant cost of misclassifying workers, it is a good idea for businesses to review the current status of their workforces and evaluate their hiring policies to ensure that they are meeting all of their obligations under federal and state law. If you believe that you have misclassified workers, look into voluntary classification settlement programs that allow you to resolve these issues with the government at the lowest possible cost.

Sidebar: Watch out for conflicting standards

Even if you are comfortable with your classification of workers for federal tax purposes, evaluate your compliance with federal wage and hour regulations as well as various state laws. These may apply different standards or look at different factors in determining a worker’s status. The U.S. Department of Labor, for example, in assessing worker status for Fair Labor Standards Act purposes, analyzes a set of factors that are similar, but not identical, to those used by the IRS. And several states have laws that make it more difficult for employers to treat workers as independent contractors.

To avoid a situation in which a worker is treated as an employee for some purposes and as an independent contractor for others, consider all applicable standards as part of the classification process.

Selling Your Home? Be Sure You Understand the Home Sale Exemption

Sky-high demand for homes, driven in large part by rock-bottom interest rates, has created a seller’s market. If you are thinking about selling your home, it is important to determine whether you qualify for the home sale exemption. The exemption is one of the most generous tax breaks in the tax code, so be sure to review its requirements before you sell.

Exemption requirements

Ordinarily, when you sell real estate or other capital assets that you have owned for more than one year, your profit is taxable at long-term capital gains rates of 15% or 20%, depending on your tax bracket. High-income taxpayers may also be subject to an additional 3.8% net investment income (NII) tax. However, if you are selling your principal residence, the home sale exemption may allow you to avoid tax on up to $250,000 in profit for single filers and up to $500,000 for married couples filing jointly.

Do not assume that you are eligible for this tax break just because you are selling your principal residence. If you are a single filer, to qualify for the exemption, you must have owned and used the home as your principal residence for at least 24 months of the five-year period ending on the sale date.

If you are married filing jointly, then both you and your spouse must have lived in the home for 24 months of the preceding five years and at least one of you must have owned it for 24 months of the preceding five years. Special eligibility rules apply to people who become unable to care for themselves, couples who divorce or separate, military personnel and widowed taxpayers.

Limitations apply

You cannot use the exemption more than once in a two-year period, even if you otherwise meet the requirements. Also, if you convert an ineligible residence into a principal residence and live in it for 24 months or more, only a portion of your gain will qualify for the exemption.

For example, John is single and has owned a home for five years, using it as a vacation home for the first three years and as his principal residence for the last two. If he sells the home for a $300,000 gain, only 40% of his gain ($120,000) qualifies for the exemption and the remaining $180,000 is taxable. (Note: Nonqualified use prior to 2009 does not reduce the exemption).

Related Read: Mixing Business and Pleasure: Tax Implications of Personal Use Rental Properties

Partial exemption

What if you sell your home before you meet the 24-month threshold due to a work- or health-related move, or certain other unforeseen circumstances? You may qualify for a partial exemption.

For example, Paul and Linda bought a home in California for $1 million. One year later, Paul’s employer transferred him to its New York office, so the couple sold the home for $1.2 million. Although Paul and Linda did not meet the 24-month threshold because they sold the home due to a work-related move, they qualified for a partial exemption of 12 months/24 months or 50%. Note that the 50% reduction applied to the exemption, not to the couple’s gain. Thus, their exemption was reduced to 50% of $500,000, or $250,000, which shielded their entire $200,000 gain from tax.

Crunch the numbers

Before you sell your principal residence, determine the amount of your home sale exemption and your expected gain (selling price less adjusted cost basis). Keep in mind that your cost basis is increased by the cost of certain improvements and other expenses, which in turn reduces your gain. Also, be aware that capital gains attributable to depreciation deductions (for example, for a home office) will be taxable regardless of the home-sale exemption.

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

Forward Thinking