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Employment Tax Tax

Worker Reclassification: Degree of Control

The Groundhog Day movie from the 90’s starring Bill Murray portrays a news anchorman who lives the same day over and over again.

He is stuck in a loop. Each day starts the same way. Bill tries to alter his conduct and he interacts with different people throughout the movie. The other characters act and react in the same way. The outcome is the same each day.

There are Groundhog Day-type tax disputes. These are tax disputes that happen over-and-over again, year-after-year, decade-after-decade. While the main character and supporting actors, the taxpayer and workers, change, that is all that changes.

The IRS’s worker classification disputes provide an example. These disputes start with workers who are paid as contractors, an IRS audit, and the IRS concluding that the workers are employees and not contractors. The taxpayer business owner is handed a large tax bill. That starts the administrative appeal process and, in many cases, tax litigation. The court cases show that this pattern has played out for a long, long time.

The recent Santos v. Commissioner, T.C. Memo. 2020-88 is the most recent case. in this long line of court cases. But luckily for the taxpayer, like Bill Murray in the movie, she broke the Groundhog Day loop. She did this by showing that she did not exercise the degree of control over the worker’s daily tasks she would have for employees.

Facts & Procedural History

The taxpayer owned a cleaning service. The cleaning service specializes in cleaning residential apartments.

When an apartment is vacated by the tenant, the property managers contact the taxpayer and the taxpayer arranges to have one of her workers clean the unit. The cleaning service also charged apartments for cleaning the common areas.

The taxpayer had previously cleaned the apartments herself, but she had stopped doing this work herself several years prior to the years at issue. Her focus during these years was to recruit and hire workers, solicit business and enter into contracts, and take calls and dispatch workers to job sites.

The taxpayer treated her workers as contractors rather than employees. The IRS conducted an audit and determined that the workers were employees and not contractors. Tax litigation ensued.

Payroll Tax vs. Employee Self-Employment Tax

Employers whose workers are employees generally have to pay payroll taxes for wages paid to the employees.

For employers, payroll taxes include FICA and FUTA. FICA pays for old-age, survivors, and disability insurance (“OASDI”) and hospital insurance. It funds Social Security and Medicare. In 2020, the Social Security tax rate is 6.2%, and the Medicare tax rate is 1.45%. The tax is computed and reported on a Form 941 that is due each quarter.

FUTA provides for unemployment taxes. These funds are provided to states to fund unemployment insurance claims. In 2020, FUTA is 6% of the first $7,000 paid to each employee annually. The tax is computed on a Form 940 that is due each year.

Employers whose workers are contractors generally do not pay payroll taxes for amounts paid to the workers. Rather, the workers pay self-employment tax on their earnings. The tax is computed and reported on the contractor’s individual tax return each year.

The self-employment tax funds the same programs as payroll taxes noted above. The rate is twice that of the payroll taxes above, but one half of the tax is deductible by the contractor for income tax purposes. Self-employment tax is triggered if the contractor had net self-employment income in excess of $400 during the year.

The IRS’s Preference for Payroll Taxes

One might think that the IRS would be indifferent as to whether a taxpayer reports amounts paid to workers as employees or contractors. The tax due to the IRS is approximately the same for both. The IRS is anything but indifferent.

The IRS has a strong preference for taxpayers to treat amounts paid to workers for services as wages rather than contract fees. The IRS’s focus is not on the amount of tax due, but the amount of tax the IRS can actually collect. The reason for this is that it is harder for the IRS to collect self-employment tax than it is payroll taxes.

Why is that? The answer is pretty simple. There are a number of contractors who simply do not report their self-employment earnings. And why is that? The answer is a bit more complex.

There are a number of reasons why self-employment taxes are not reported or paid. It includes contractors who is not aware of the rules. It includes contractors who are cheating and simply avoiding the tax.

There are other reasons too. Immigration issues are high on the list. There are quite a few lower-skilled and/or labor-intensive jobs in the U.S. These jobs have to be done. Despite the politics of it, illegal aliens and those new to the U.S. often fill these roles. They often do so at a price point that is much cheaper than a citizen would demand. This lower pay is often required due to the fact that customers are not willing to pay higher amounts for this work.

Businesses cannot withhold and remit payroll taxes for these workers or treat them as employees given the worker’s residency and work restrictions. As a default, these workers are often paid as contractors. They may also be paid in cash.

Given their immigration issues, they may not be able to report self-employment earnings or may not even know how to go about doing so. It is easier for the IRS to pursue the business than it is for the IRS to detect and pursue the worker in these cases. That is exactly what the IRS does.

As tax attorneys in Houston, Texas, this is the context in which we see most employee-vs-contractor disputes. It is the lower-skilled and/or labor-intensive jobs. It often involves work that U.S. citizens will not do or work that they won’t do for a price that the end customers are willing to pay.

This brings us back to the Santos case. The tax dispute in Santos is the classic example of a worker-classification dispute.

Degree of Control

There are regulations and a well-developed body of case law that helps to define when a worker is an employee for tax purposes.

The court in Santos noted the factors that are to be considered in determining whether a worker is an employee or a contractor. These factors include:

  • The degree of control exercised by the principal over the worker;
  • Which party invests in the work facilities used by the worker; (3) the worker’s opportunity for profit or loss;
  • Whether the principal can discharge the worker;
  • Whether the work is part of the principal’s regular business;
  • The permanency of the relationship; and
  • The relationship the parties believed they were creating.

In applying the factors, the courts have consistently said that the first factor is the most important. If the taxpayer exercises a high degree of control over the worker, then the worker is an employee for tax purposes.

The courts have further refined this to say that the degree of control is not viewed broadly. It is limited to control over the daily tasks that the worker is to perform. The Santos case highlights this:

Petitioner contends that she did not control her workers in a manner that would establish an employer-employee relationship because she did not have the right to control the manner and means by which the cleaning work should be accomplished. We agree with petitioner.

….

Petitioner directed her workers as to the result to be accomplished and expected the result to be done in accordance with the contracts’ specifications and in turn to the satisfaction of the property managers, but she otherwise allowed her workers to use their discretion as to the means and methods of accomplishing this result. 

The court found this to be of more importance than the fact that the taxpayer had the contracts with its customers, the taxpayer maintained workers compensation for the workers and commercial general liability insurance, and that some of the workers assisted the taxpayer for several years.

According to the court, these additional facts did not provide “definitive evidence that petitioner had the requisite degree of control over her workers.”

The Takeaway

Just because collecting tax from the taxpayer business rather than the workers is easier for the IRS is not a valid reason for shifting this tax to the business.

The Santos case shows that taxpayers should not accept the IRS’s assertions on face value.

It reminds taxpayers who pay contractors to document that they do not control the performance of the worker’s daily activities.

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