2008 01 Intro - Chapter 1: Employment Taxation Employee...

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Unformatted text preview: Chapter 1: Employment Taxation Employee versus Independent Contractor................. 2 Section 530 Relief........................................................ 11 Statutory and Nonstatutory Employees ................... 16 Employment Tax Treatment...................................... 23 Household Workers.................................................... 29 Reporting Fringe Benefits on the W-2...................... 35 Miscellaneous Payroll Rules...................................... 36 1 Please note. Corrections for all of the chapters are available at www.TaxSchool.uiuc.edu. For clarification about acronyms used throughout this chapter, see the Acronym Glossary at the end of the Index. Employment taxation compliance continues to interest the IRS. In 2008, a new form was created to report uncollected social security and Medicare tax on wages. A worker classified by an employer as an independent contractor, but who is actually an employee, can report and contribute his share of FICA and Medicare taxes using Form 8919, Uncollected Social Security and Medicare Tax on Wages. Information about this form is covered later in the chapter. The Internal Revenue Manual identifies three goals for employment tax area compliance: 1. Ensure all employers and workers are filing timely, accurate, and fully-paid returns; 2. Ensure workers are properly classified as employees or independent contractors; and 3. Ensure all remuneration subject to employment tax is reported.1 This chapter mainly focuses on information related to the second goal. As emphasized in a November 2007 Tax Talk Today webcast, employment taxation continues to be an important issue. Properly classifying workers as either independent contractors or employees continues to concern the IRS. Much of the material for this chapter is based on information found on the IRS website and the IRS audit training manual entitled Independent Contractor or Employee? Even though this manual was written in 1996, the IRS still uses it to train auditors.2 On November 6, 2007, the IRS entered into a Questionable Employment Tax Practices (QETP) Memorandum of Understanding (MOU) with 29 state workforce agencies3 to exchange information for the purpose of identifying employment tax schemes and practices that have no objective other than avoiding federal or state employment tax.4 In particular, the purpose of the MOU is to: 1. 2. 3. Increase compliance with federal and state employment tax filing and payment regulations, Increase compliance with Form 1099 and Form W-2 filing, Increase collection of federal and state employment/unemployment tax debts, Enhance efforts to reduce the tax gap at the federal and state levels, and Ensure businesses operate on a competitive. level playing field and pay their proper share of employment taxes. IRM 4.23.2.2 www.irs.gov/pub/irs-utl/emporind.pdf. Accessed on June 6, 2008. Arizona, Arkansas, California, Colorado, Connecticut, Hawaii, Idaho, Kentucky, Louisiana, Maine, Massachusetts, Michigan, Minnesota, Nebraska, New Hampshire, New Jersey, New York, North Dakota, Ohio, Oklahoma, Rhode Island, South Carolina, South Dakota, Texas, Utah, Vermont, Virginia, Washington, and Wisconsin FS 2007-25 (November 6, 2007) 4. 2008 Chapter 1: Employment Taxation 1 Copyrighted by the Board of Trustees of the University of Illinois. This information was correct when originally published. It has not been updated for any subsequent law changes. In other IRS efforts to support improved worker classification, Circular 230, Regulation Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries and Appraisers Before the Internal Revenue Service informed tax practitioners that if they know of inappropriate tax treatment of employees, they have a requirement to notify the taxpayer, and if necessary, remove themselves from the engagement. Although several employment taxation compliance areas are of concern, the IRS focuses a lot of effort on the proper classification of workers. Are workers independent contractors or are they employees? EMPLOYEE VERSUS INDEPENDENT CONTRACTOR The consequences of treating an employee as an independent contractor can be severe. If a worker is misclassified as an independent contractor, the employer may be liable for employment taxes for that worker. If the employer is not eligible for Section 5305 relief provisions (discussed later), the employer may have liability beyond the unpaid employment tax depending upon the employer's particular circumstances for not paying the tax.6 Incorrectly classifying workers can also affect qualified retirement plans, health insurance, workers' compensation, and unemployment insurance. If employers misclassify workers as independent contractors, the employer's retirement plan could be disqualified if it doesn't meet certain tests. If a worker is classified as an independent contractor and has a self-employed retirement plan, and then is reclassified as an employee, he could be subject to substantial penalties for overcontributing to his self-employed retirement plan. Correctly classifying workers is crucial to both the employer and the worker.7 IRC 3121(d) contains four categories of employees for purposes of FICA tax. A worker is classified as an employee if he is one of the following: A common-law employee; A corporate officer; An employee as defined by statute, commonly referred to as a "statutory employee;" or An employee covered by an agreement under Section 218 of the Social Security Act. By statute, workers in three occupations are not treated as employees, and are commonly referred to as statutory nonemployees. 8 They are not classified as employees for purposes of FICA, FUTA, or federal income tax withholding as long as they meet specific qualifications. These workers are: Real estate agents, Direct sellers, and Companion sitters. COMMON-LAW STANDARD The common-law standard is used to determine a worker's status. This standard was created through actions taken by the courts over many years. Under common law, the treatment of a worker as an independent contractor or an employee originates from the legal definitions developed in the law of agency action -- whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent -- and depends on the principal's right to direct and control the agent. 5. 6. 7. 8. Section 530 of the Revenue Act of 1978 IRC 3509 "What's Hot in Employment Taxes: Independent Contractor or Employee?," Tax Talk Today (November 6, 2007) IRC 3508 and 3506 2 2008 Chapter 1: Employment Taxation Copyrighted by the Board of Trustees of the University of Illinois. This information was correct when originally published. It has not been updated for any subsequent law changes. Following the common-law standard, employment tax regulations provide that an employer-employee relationship exists when the business has the right to direct and control the worker who performs services for the business. An employee is subject to the will and control of the business not only in regard to what work is done, but also how it is done. It is not necessary that the business actually directs or controls the manner in which the services are performed; it is sufficient if the business has the right to do so. This is true even if the employer gives the employee freedom of action. If an employer-employee relationship exists, it doesn't matter what the relationship is called. The employee may be called an "agent" or "independent contractor." If an employer-employee relationship exists, how payments are measured or paid, or what payments are called has no bearing on the classification of the worker. It also doesn't matter if the employee works full- or part-time.9 Over the years, the IRS and the Social Security Administration compiled a list of 20 factors used in court decisions to determine worker status. These factors were eventually published in Rev. Rul. 87-41 and are sometimes called the Twenty Factor Test. The Twenty Factor Test is an analytical tool. It is not the legal test used for determining worker status. The legal test is whether there is a right to direct and control the means and details of the work. Since the list of 20 factors was developed over 20 years ago, some of the factors are no longer as relevant as they once were. For example, one of the 20 factors deals with the place of employment. Twenty years ago, there were few telecommuters, whereas now, telecommuting is quite common. In 1996, the IRS categorized the 20 factors into three types of evidence that are now used to evaluate independent contractor status. When determining worker classification, the following facts in all categories are considered. 1. Behavioral control 2. Financial control 3. Relationship of the parties 1 Behavioral Control Whether the employer has the right to direct or control how a worker does his work determines behavioral control. Even if the employer doesn't actually direct or control the way work is done, it is sufficient if the employer has the right to direct or control the work.10 Examples of ways employers direct and control how work is done are to provide instruction and training. Other factors that may influence worker classification are performance evaluation systems, worker identification, and the occupation of the worker. Instruction. Virtually every business instructs workers on how to accomplish the job, whether they are independent contractors or employees. Therefore, the fact that a business provides instruction is not sufficient to determine the worker's status. Does the business retain the right to control the details of a worker's performance, or does it give up its right to control the details? Do instructions apply to how the job gets done rather than the end result? If the focus of instruction is how the work is to be done, then the worker is likely classified as an employee. Instructions about how to do the work may cover a wide range of topics, including: 9. 10. When to do the work, Where to do the work, What tools or equipment to use, What workers to hire to assist with the work, What work must be performed by a specific individual (including ability to hire assistants), What routines or patterns must be followed, and What order or sequence to follow. IRS Pub. 15, Circular E, Employer's Tax Guide IRS Pub. 1779, Independent Contractor or Employee? 2008 Chapter 1: Employment Taxation 3 Copyrighted by the Board of Trustees of the University of Illinois. This information was correct when originally published. It has not been updated for any subsequent law changes. ...
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