Tax Alert: Independent Contractors and the IRS: Reversal of Obama Overtime Rule

Independent Contractors and the IRS

Although there has been a recent loosening of some Department of Labor rules regarding independent contractors, employers could still find themselves on the hook for employment taxes for workers they don’t consider employees. It’s important to remember that employment-related tax laws are enforced not by the DOL but by the IRS. Generally, employers must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. They aren’t required to withhold or pay any taxes on payments to independent contractors.

The IRS focuses on the employer’s right to control the details of how the worker’s services are performed. It considers three categories of factors related to the degree of control:

  1. Behavioral control. This refers to facts that show whether the employer has the right to direct or control how the individual performs the work. The employer need not actually direct or control the way the work is done so long as it possesses the right to do so. Instructions, training and performance evaluations can indicate that the employer has that right. Detailed instructions about how to do work, training on procedures and methods, and evaluation systems that measure the details of how work is performed (vs. the end result) all suggest an employment relationship.
  2. Financial control. This category includes evidence that the employer has the right to control the economic aspects of the job. If the worker incurs significant unreimbursed expenses, has a major investment in the business, provides the tools or supplies needed to perform the job and is available to work for other companies or clients, he or she is more likely to be an independent contractor. The method of payment also is relevant. Employees generally are guaranteed a regular wage amount for an hourly, weekly or other period of time, while independent contractors typically are paid a flat fee.
  3. Type of relationship. The final category encompasses facts that show how the worker and employer perceive their relationship. For example, providing a worker with traditional employee benefits, such as insurance, pension plans, paid vacation, sick days and disability insurance, can indicate the employer’s intent to treat the worker as an employee. However, the lack of benefits doesn’t necessarily mean the worker is an independent contractor. The IRS also considers whether the relationship is expected to continue indefinitely, as opposed to only a specific project or period.

Other areas the IRS focuses on include whether a worker provides services that are a key part of the business. If this is the case, the business is more likely to have the right to direct and control his or her activities. Be aware that a written contract stating that the worker is an employee or independent contractor is not controlling. It’s how the parties work together that settles the matter.

Misclassification Relief

Employers that have misclassified employees as independent contractors might qualify for tax relief from the IRS’s Voluntary Classification Settlement Program (VCSP). Under the program, eligible employers can voluntarily reclassify workers as employees going forward.

To participate, an employer must currently treat the workers as independent contractors or other nonemployees and have consistently treated them that way. Employers also must have filed all required Forms 1099 for the workers for the previous three years. An employer cannot currently be under an IRS employment tax audit or under DOL audit regarding worker classification.

In exchange for reclassifying workers, an employer’s liability for past payroll obligations is reduced to only 10% of the taxes that may have been due on compensation paid to the workers for the most recent tax year — a substantial savings. Employers also are excused from any interest or penalties and can’t be subject to an employment-tax audit on the classification of workers in previous years. Consult with us about this program before contacting the IRS.

Overtime Rule from Obama Administration Struck Down by Court

One additional news item that should be of interest to many employers is a recent court decision on a controversial overtime pay rule that came out late last year. Last month, a federal judge in Texas overturned a rule implemented by the Obama administration which would have doubled the salary level for exemption from overtime from $23,660 to $47,476. This rule would have made $47,476 the minimum annual salary a worker would have to earn before they could be considered “managerial” and thus exempt from Federal law requiring time-and-a-half pay for all hours worked over 40 in a week.  The judge ruled that the Obama administration interpretation of the Fair Labor Standards act was unreasonable, and that the Department of Labor should not be able to make salary rather than an employee’s duties the deciding factor of whether a “bona fide executive, administrative or professional capacity” employee should be exempt from being paid overtime. Many business-related organizations have commented that the higher salary levels would cause many managers to be caught up in this rule. Because this decision still pending appeal by the DOL, it may not be considered final but certainly provides more flexibility to employers.

Proceed with Caution

If you’re uncertain about whether a particular worker is an employee or independent contractor, or how the overtime pay rules might impact your business from a financial perspective, contact us. We can help you navigate the relevant tax laws and regulations.

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