Nonprofit organizations differ from for-profits in a number of ways, but there are certain areas where the two overlap. One such area is classification of workers as employees or independent contractors, which has been of increasing interest to the IRS. For nonprofits and for-profits alike, misclassification can have serious consequences.
The IRS has been studying worker classification has part of its National Research Program for several years now. The reason? The IRS estimates that employers misclassify millions of employees as independent contractors, which means much less tax money in the federal coffers.
To illustrate, when an employer classifies a worker as an employee, the employer is required to withhold federal income taxes from salaries, as well as the employee’s share of Social Security and Medicare taxes. The employer also needs to pay the employer’s share of Social Security and Medicare taxes, and all federal unemployment taxes. There are generally state withholding requirements, as well. When an employer classifies a worker as an independent contractor, the worker is responsible for paying all income tax, as well as the entire amount of Social Security and Medicare taxes. The employer has no withholding obligation and does not have to pay unemployment taxes, and the worker does not always pay the full tax owed.
The Classification Test
On average, the IRS estimates that an employer can save about $3,710 per worker per year by misclassifying an employee as an independent contractor. So while it seems there could be incentive for employers to misclassify, the reality is that it is not always crystal clear which category should apply to a worker. In general, the key factor is whether the employer exercises the requisite amount of control over the worker, and there is not always a bright line answer. Under federal tax law, classification turns on a test focusing a variety of factors within three main categories:
- Behavioral: this focuses on the amount of control the employer has over the work, and considers the types of instructions given; the degree of instruction; the evaluation systems in place for the worker; and the training provided. In general, if an employer is focused on end result only, that indicates an independent contractor relationship. However, if an employer has control over the method of performing the work, that indicates an employee relationship.
- Financial: this focuses on economic aspects of the worker’s job, including the worker’s investment in equipment; reimbursement of expenses; opportunity for profit or loss; other business opportunities; and method of payment. In general, an employee likely will not have invested in equipment, will get expenses reimbursed, has no opportunity for profit or loss, is guaranteed an hourly rate or salary, and will not seek out other business opportunities.
- Type of Relationship: this focuses on how the employer and work view their relationship, and considers whether there is a written contract; whether employee benefits are provided; the permanency of the relationship; and whether the services provided by the worker are a key activity of the business. A written contract and provision of benefits will not guarantee status as an independent contractor or an employee, though it can provide strong support.
Risk of Misclassification
Misclassifying an employee as an independent contractor can mean penalties and back withholding taxes will be imposed on the employer. There is relief from tax liability (known as “Section 530 relief”) for certain employers who misclassified workers based on the common law test. However, the employer must meet certain requirements:
- Reporting consistency: the employer must have filed all required tax returns (including information returns like 1099s) consistent with its treatment of each non-employee worker;
- Substantive consistency: the employer must have treated similar employees consistently (i.e., not treating some as employees and some as independent contractors);
- Reasonable basis: the employer had a reasonable basis for not treating workers as employees, such as a court case, IRS rulings, a past IRS audit or a long-standing practice of a significant segment of the relevant industry.
It is a good idea for nonprofits to be familiar with the above requirements, and ensure that their treatment of any workers they classify as independent contractors complies. A business or a worker also can elect to get a determination letter from the IRS on proper classification status, using the SS-8 Program. However, a recent report issued by the Treasury Inspector General notes that the SS-8 Program has been somewhat bogged down in terms of processing times, and recommends some changes in order to improve this.
An interesting aspect of the report is that not all employers are complying with the results of such determination letters. Improving employer compliance with SS-8 determinations is an outlined goal in the report, so employers should be prepared to do so.