Classification decides which form a client files. An employee gets a Form W-2 and triggers withholding and the employer share of payroll taxes. A contractor gets a Form 1099-NEC and no withholding. The cost of getting it wrong sits with the payer, and it often surfaces during an audit of payroll, an unemployment claim or an IRS employment tax examination. This article sets out the IRS framework and a review workflow a CPA firm can apply during onboarding and at year end.
The IRS framework
The IRS looks at the facts through three categories of evidence on control and independence:
- Behavioral: does the company control, or have the right to control, what the worker does and how the worker does the job?
- Financial: are the business aspects of the worker's job controlled by the payer?
- Type of relationship: are there written contracts or employee-type benefits, and what is the permanence of the arrangement?
The IRS states that no one factor stands alone in making this determination. The business weighs all the factors together. A written contract that labels a worker an independent contractor does not control the outcome when the facts say otherwise.
Turning the categories into questions
Behavioral control
- Does the client set hours, locations or sequencing of work?
- Does the client train the worker in its methods?
- Does the client supply detailed instructions, or specify only the result?
- Does the client evaluate how the work is done, or only whether the deliverable meets the specification?
Financial control
- Does the worker have unreimbursed business expenses, their own tools and an investment in the work?
- Does the worker offer services to the market, with other clients?
- Is the worker paid by the hour or week, or by the project?
- Can the worker make a profit or suffer a loss?
Relationship
- Is there a written agreement, and does it match how the parties behave?
- Does the client provide benefits such as insurance, retirement contributions or paid leave?
- Is the arrangement open-ended or tied to a defined project?
- Is the work a key part of the client's regular business?
A firm should record the answers in a short memo for each flagged worker. The memo is the evidence the position was reasoned if the IRS asks.
Resolving uncertainty
If it is unclear whether a worker is an employee or a contractor, either the business or the worker can file Form SS-8 with the IRS. The IRS reviews the facts and issues an official determination. The IRS notes that a determination can take at least six months, so Form SS-8 does not fit a filing deadline.
The Voluntary Classification Settlement Program is an optional program that gives taxpayers an opportunity to reclassify their workers as employees for future periods. Applicants file Form 8952. The IRS says eligibility requires that the business consistently treated the workers as nonemployees and filed all required Forms 1099 for the previous three years, and that it is not under an IRS employment tax audit or a Department of Labor or state audit on the classification. The payment is 10 percent of the employment tax liability for the most recent tax year, computed under the reduced rates of section 3509(a), with no interest or penalties on that amount. Check the Form 8952 filing timing on the IRS page before recommending it.
Section 530 relief and Form 8919
Section 530 of the Revenue Act of 1978 can relieve a business of employment tax liability for workers it treated as nonemployees, even when they would be employees under the common-law test. Publication 1976 states three requirements: reporting consistency (all required Forms 1099 filed on a basis consistent with the treatment), substantive consistency (no treatment of the worker, or anyone in a substantially similar position, as an employee after 1977) and a reasonable basis for the treatment. The IRS says relief does not make the worker an independent contractor. A worker who believes he or she was misclassified can use Form 8919 to report the employee share of uncollected Social Security and Medicare taxes.
Where misclassification shows up
- Information returns. A 1099-NEC to a worker with a manager, a schedule and a company laptop is a flag.
- Payroll tax accounts. A client with no payroll but a large contract labor line is a flag, as is a contractor who becomes full time.
- Owner-managers. Officers who work in an S corporation and are paid through distributions are a related issue, covered in S corporation reasonable compensation.
- Seasonal staff. A seasonal workforce on 1099s deserves the same three-category review as any other group of individuals.
Firm workflow
- Intake. Add a worker classification question to the engagement questionnaire: how many 1099 recipients, how many are individuals, what do they do and who supervises them.
- Sample the 1099 list. Pull recipients paid above the reporting level and apply the three-category questions to each individual who is not clearly in business for themselves.
- Document conclusions. For each individual, record the facts, the conclusion and the date. Keep the W-9 and the contract.
- Escalate. Where the facts point to employee status, tell the client in writing and present the options: reclassify prospectively, use the settlement program, or request a determination.
- Fix the information returns and payroll. If the client reclassifies, update payroll set-up, tax deposit schedules and the 1099 file together. See payroll tax deposits.
The audit angle
For clients whose financial statements are audited or reviewed, misclassification can mean an unrecorded liability for payroll taxes, penalties and interest, and a loss contingency under ASC 450 when the exposure is probable and estimable. Auditors compare the contract labor expense with payroll records and the 1099 file. See ASC 450 loss contingencies and the glossary entry on worker classification.
FAQ
Does a signed contractor agreement settle the question?
No. The IRS weighs the behavioral, financial and relationship facts together. A label in a contract is one fact among many.
Who can file Form SS-8?
Either the business or the worker.
Is the settlement program retroactive?
The IRS describes it as reclassification of workers as employees for future periods.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- IRS, Independent contractor (self-employed) or employee: https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
- IRS, Voluntary Classification Settlement Program: https://www.irs.gov/businesses/small-businesses-self-employed/voluntary-classification-settlement-program
- IRS, Publication 1976, Do You Qualify for Relief Under Section 530: https://www.irs.gov/pub/irs-pdf/p1976.pdf
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error