Avoiding Misclassification of Dual-Status Workers Under IRS Rules
By: EMMA SADIKOVICH
In this article, Sadikovich discusses the practical implications for businesses and individuals when a worker is classified as both an employee and an individual for tax purposes.
Copyright 2018 Emma Sadikovich. All rights reserved.
A business must determine whether to treat a worker as an employee or independent contractor for federal employment and income tax withholding purposes. Generally, the business must withhold federal, state, and local income taxes, and withhold and pay employment taxes such as Social Security and Medicare (FICA) on compensation paid to employees. The business must also pay federal and state unemployment taxes. On the contrary, a business doesn’t have to withhold or pay any employment, income, or unemployment taxes for compensation paid to independent contractors because independent contractors are responsible for paying their own taxes, including FICA payroll taxes. Further, independent contractors may enjoy favorable tax treatment under section 199A compared with employees.
In some circumstances, a worker may be an employee in one capacity and an independent contractor in another for the same business. That worker is generally considered a dual-status worker, performing one type of service for a business as an employee and a different type as an independent contractor.1 The courts and the IRS have recognized this classification. The Department of Labor uses a different test for defining an employee, and the discussion in this article focuses solely on the dual-status classification for IRS purposes.
If a business uses the services of a dual-status worker, it will issue the worker a Form W-2 for wages earned as an employee and a Form 1099 for services performed as an independent contractor if the payments for the independent contractor services meet the $600 threshold.
The IRS confirmed that a person who is an officer — and hence, a statutory employee — may also be an independent contractor at the same company for the performance of sales services, because the sales services at issue were separate and distinct activities and unrelated to his services as an officer.2 Similarly, an individual who acted as both a real estate agent and the firm’s office manager was deemed a dual-status worker by the IRS.3 The IRS determined that the worker’s services to the firm as the office manager were those of an employee and the services to the firm as a real estate agent were those of an independent contractor.
In an information letter (INFO 2012-0069), the IRS provided guidance for an individual who simultaneously provides services in two separate roles for the same business. In such situations, the IRS separately examines the relationship between the worker and the business for each service provided, focusing on three categories: behavioral controls, financial controls, and type of relationship between the parties. In the past, the IRS considered 20 factors in evaluating whether a worker is an employee or an independent contractor; however, the agency has grouped the 20 factors into the three categories specified above.4
For example, in Reece,5 the Tax Court held that a full-time university professor who in his spare time provided seminars to multiple clients — some of which were taught through his employer’s executive education program in classrooms provided by his employer — was an employee in his capacity as a professor for the university but an independent contractor regarding his teaching of corporate seminars. The court reasoned that the professor was an independent contractor when he held corporate seminars because other seminar providers were independent contractors when they provided those services to the university. “The fact that petitioner is an employee of the University in one capacity does not foreclose the possibility that he may independently contract with the University in another capacity,” the court said.
In another case, a radio personality rendered promotional services to his sponsors that weren’t among the duties specified in his employment agreement with the radio station.6 The employer acted as a conduit for payment of the promotional service fees by the sponsors and included regular pay plus an amount broken out as talent and remote fees on the individual’s W-2. After weighing the list of independent contractor factors, the court determined that it favored independent contractor treatment for the promotional work because (1) promotional services were outside the scope of his employment; (2) his earnings depended on satisfying the (3) only the sponsors could terminate the promotional relationship; (4) compensation under his employment agreement wasn’t affected by his success in the promotional work; and (5) the sponsors each believed the relationship was between the radio personality and the sponsor.
Some states follow IRS guidelines in determining a worker’s status under unemployment insurance laws; the states may use the same or a similar test in doing so. For example, in Missouri, a holding company’s paralegal performed additional work for the holding company during the evenings and on weekends.7 [ps2id id=’seven’ target=”/] The after-hours work ranged from document preparation to cleaning to the transport of clients. The court concluded that the paralegal was acting as an independent contractor, rather than an employee, regarding her after-hours work for the employer. The court said the after-hours services the employee provided were distinguishable from the paralegal’s job duties such as preparing applications and conducting research.
If an employee, in addition to his employment services, has a business that performs independent contracting services in a different capacity for the employer, the worker will typically be considered an independent contractor in that capacity. However, this doesn’t mean that the worker will be de facto classified as an independent contractor concerning those services. In cases of clear abuse, an employee’s separate business may be disregarded.8
Despite the IRS’s recognition of the dual-status worker, a business that issues both Form W-2 and Form 1099 to the same individual in the same year will most likely invite additional scrutiny from the IRS. The IRS has noted in the past that it will closely examine individuals receiving both a Form W-2 and a Form 1099 from the same business within the same tax year. In the past few years, the IRS and state agencies have increased the number of worker classification audits, in which they examine and evaluate whether a business has classified its workers correctly, either as employees or independent contractors.
It’s imperative that the business maintain documentation and evidence such as independent contractor agreements, job descriptions, and invoices issued to an employee’s business to support the dual-status treatment of a worker, keeping in mind the three categories noted above that the IRS examines in determining worker classification. In the event of an IRS worker classification audit, comprehensive documentation is key because it may bolster the company’s case that it had a reasonable basis for treating the worker as an independent contractor. If the IRS finds that an independent contractor should have been classified as an employee, the agency may retroactively impose employment taxes on the employer and assess interest and potentially severe financial penalties.
For a dual-status worker, a written agreement between the parties that specifies the independent contracting services the worker performs may support the independent contractor status. However, the existence of such a contract is insufficient when the relationship is that of an employer-employee. Maintaining documentation from legal advisers regarding worker classification is also key.
Simply issuing a Form 1099 for independent contracting services to a worker doesn’t automatically prove that a worker is an independent contractor. Further, the IRS doesn’t simply determine each worker’s status by looking at the job title. If an employee has a business that performs unrelated services, this may provide a strong basis for independent contractor classification regarding those services. If there is uncertainty whether a worker should be classified as an employee or an independent contractor, an experienced legal counsel or a tax adviser should be consulted.
Misclassification of a worker may create a substantial tax liability for a business. In addition to payment of back employment taxes — and in some instances, interest and penalties — the business might have to include its misclassified workers in its 401(k) plan, employee stock purchase plan, and other employer-provided benefits.9 If a dual-status worker’s independent contracting services are misclassified and the worker is a nonexempt employee, the business will have to add misclassified hours to the employment hours, which might trigger overtime liability. The misclassification can also trigger an unemployment insurance audit and unemployment insurance tax liability.
[ps2id id=’1′ target=”/]1 Rev. Rul. 58-505, 1958-2 C.B. 728.
[ps2id id=’2′ target=”/]2 Id.
[ps2id id=’3′ target=”/]3 LTR 200033014.
[ps2id id=’4′ target=”/]4 Rev. Rul. 87-41, 1987-1 C.B. 296.
[ps2id id=’6′ target=”/]5 Reece v. Commissioner, T.C. Memo. 1992-335.
6 Ramirez v. Commissioner, T.C. Summ. Op. 2013-38.
[ps2id id=’7′ target=”/]7 National Heritage Enterprises v. Division of Employment Security, 164 S.W.3d 160, 163 (Mo. Ct. App. 2005).
8 Sargent v. Commissioner, 93 T.C. 572 (1989).
9 See Vizcaino v. Microsoft Corp., 97 F.3d 1187 (9th Cir. 1996); and Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997), cert. denied, 118 S. Ct. 899 (1999).
MAGAZINE CITATION TAX NOTES, OCT. 1, 2018, P. 47161 TAX NOTES 47 (OCT. 1, 2018)
TAX ANALYSTS DOCUMENT NUMBER DOC 2018-34299