Uber, a $50 billion worldwide company that matches drivers with passengers using cutting-edge technology, faces a battle in California over whether its drivers are employees or independent contractors. It is a question that many startups are facing, but is an old problem that many small and medium-sized firms encounter.
While the Uber case involved a labor law issue, the IRS is actively pursuing this issue on a federal level against numerous companies because of the potential for damage to the fisc.
This article outlines the Uber issue, then delves into the federal tax issues that employers face when deciding whether their workers are employees or independent contractors.
A quick review of the Uber ruling: This past June, a hearing officer of the California Labor Commission found that an Uber driver was an employee for state labor law purposes. The finding is nonbinding and applies to that driver only, but the case has garnered much attention. Uber has more than 160,000 drivers throughout the United States.
From a federal tax perspective, the question of whether a worker is an independent contractor or employee is decided on some common law issues, as well as IRS regulations. What is at stake?
Employers want workers to be classified as independent contractors to:
- Save on the employer’s portion of Social Security and Medicare payroll taxes.
- Not have to include the worker in the company’s healthcare and retirement plans.
- Not have to pay state unemployment taxes.
- Allow for easier termination of a contract for services rather than having to fire an employee.
The IRS wants workers to be classified as employees because it results in:
- Speedier tax receipts. Employers submit payroll and income taxes to the IRS on a monthly basis. Independent contractors only submit taxes on a quarterly basis.
- Increased tax receipts. Employees cannot deduct from their income business expenses. Independent contractors can. This leads to lower tax revenue from an independent contractor.
- Lower cost of audits. Because employers effectively take care of an employee’s tax computation, there is not much concern about potential tax evasion. But because independent contractors compute their own taxes and are able to deduct business expenses, the IRS must commit resources to audit their returns.
The bottom line is the IRS wants workers to be classified as employees as much as possible, and the burden of proving that a worker is an independent contractor rests on the employer.
This issue has been around for a while. The IRS views workers as potentially one of the following types: independent contractor, employee, statutory employee, or statutory nonemployee.
Statutory employees include certain drivers (those who distribute meat, vegetables, fruit, or bakery products; beverages other than milk; or laundry or dry-cleaning services for their principal, and who meet other requirements), life-insurance salespeople, home workers, and other salespeople. Statutory nonemployees include qualified real-estate agents and direct sellers. They are treated as independent contractors. But for all other workers, employers, as instructed by the Internal Revenue Code, first look to common law principles and then to the IRS’s 20-point checklist to help them make a decision.
The IRS has identified three categories of evidence that may be relevant in determining whether the requisite control exists under the common law test and has grouped illustrative factors under these three categories:
- Behavioral control
- Financial control
- Relationship of the parties
The IRS emphasizes that factors in addition to the 20 points may be relevant, that the weight of the factors may vary based on the circumstances, that relevant factors may change over time, and that all facts must be examined.
If the employer can’t decide, the employer can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS and the IRS can make a decision. It could take six months, but might be worthwhile if the employer is hiring many of the same type of worker to perform a particular service.
If an employer misclassifies a worker as an independent contractor, without reasonable basis, then the employer will be liable for underwithheld income and employment taxes. If there is reasonable basis, then the employer can ask the IRS for relief from having to pay previous employment taxes. And, employers can opt into a Voluntary Classification Settlement Program that will allow them to reclassify independents as employees for future tax periods with partial relief from having to pay past employment taxes.
The employee/independent contractor issue is one that existed before Uber, and it will continue long after, as long as the Internal Revenue Code and state labor laws make financial distinctions between the two. The IRS would prefer that the classification for a worker default to employee. Employers, working with tax advisors, have to build a case to overcome that default.
About Michael Sonnenblick
Michael Sonnenblick, J.D., LL.M., currently serves as an editor/author with Thomson Reuters Checkpoint within the Tax & Accounting business of Thomson Reuters. Michael holds a J.D. degree from Boston University School of Law and an LL.M. in Taxation from New York University Law School. A member of the New York Bar, Michael has 20 years of tax experience, including service with a major Wall Street bank and international law firms. In addition, he has represented clients before the IRS. Michael’s specialties include individual taxation and retirement planning.