Are they employees or independent contractors? How they may actually be BOTH...and the IRS might agree...sort of.
For business owners, the decision on how to classify those who work for them is very important. It's been known for a while that worker classification matters are one of the key target areas for the IRS, and in an era of constant cutbacks and budget shortfalls, it's an area that will continue to have their attention. As recently as the summer of 2014, the IRS announced that it was stepping up its audits of S Corporations, largely due to what has been perceived as abuses in this area. Combined with a joint information-sharing initiative between the IRS and the U.S. Department of Labor to ensure that such misclassifications are minimized, it's clear that this is an area of focus among multiple government agencies and demands attention from business owners and their advisors.
But what about instances where it makes sense to have employees do additional work after hours that a company would have normally hired outside help to do? For example, what if Jane from Accounting who happens to have a penchant for graphic design is hired to design the new logos to be put on the company's delivery trucks? Or what if Tom from Operations is tabbed to make deliveries after work of critical items for the freight delivery company he works for that the company would have otherwise hired an independent delivery company to handle? Clearly, these examples offer up situations where the roles Jane and Tom are being paid to fill are completely different. Might that thus allow the companies that employ them for the former role to treat them differently for withholding tax purposes while performing the latter duties?
The Office of Chief Counsel - which represents the IRS in disputes before the United States Tax Court in worker classification matters - has recognized that such a dichotomy can exist. In late 2012, the Office of Chief Counsel issued an information letter addressing this topic. See Office of Chief Counsel Information Letter 2012-0069, released December 28, 2012. Importantly, the information letter was provided to a member of Congress on behalf of a constituent, and Chief Counsel emphasized that the letter was for informational purposes only and did not constitute a ruling. The inquiry centered around whether or not the same individual can be both an employee and an independent contractor simultaneously for the same company. While the inquiry posed this question in the context of the individual working as a consultant on two separate consulting projects, those specifics weren't central to the analysis put forth in the information letter. Rather, the letter focused on analyzing the same factors used to evaluate whether an individual falls into the "employee" or "independent contractor" column that's used in all such cases. Those factors focus on the relationship between the worker and the business, and the facts and circumstances of each case are generally categorized and reviewed within a construct of: 1) behavioral controls; 2) financial controls; and 3) the relationship of the parties. When one analyzes these factors hile evaluating individual workers, you can quickly begin to see how in case where one individual occupies these "dual roles" within the same company, some factors both favor AND disfavor one status simultaneously. For example, when looking at the financial control factor in relation to Jane up above, it would likely be clear that when it comes to her performing her function as an accountant, she'd probably fail in all respects to qualify as an independent contractor assuming the situation isn't very unusual. Jane's risk of making a profit or a loss, her making her accounting services available to the market at large (unlikely to be allowed), and her incurring a bunch of unreimbursed expenses while performing the accounting function (unless she forgets to turn in her receipts) are likely going to tip heavily toward "employee" status. However, when it comes to her graphic design work, a look at those same factors may yield a very different outcome. Jane may have purchased the design software she uses on her own and it may be on her home computer, which is where she's usually fiddled around with graphic design in the past. Perhaps she's taken graphic design classes on her own dime as well, and purchased other related supplies needed to produce the designs. Maybe she's even got her own website where she markets her talents to other businesses or individuals that she also pays for. Clearly, the scale has tipped considerably the other way when looking at Jane's situation from this angle. The information letter makes it clear that a role-based approach is necessary in these "dual role" situations, and provides that "[i]n instances where an individual provides services in two separate roles to the same business, the IRS examines separately the relationship between the worker and the business for each performance of service . . . [i]f an employer-employee relationship is found with regard to the performance of services for only one role of the worker, remuneration with regard to only those specific services is subject to all FICA and income tax withholding requirements under the Code."
Interestingly, in our practice, we've seen an increased number of instances where the IRS has attempted to "recharactize" the amounts paid to employees for their second role (where they'd been paid as independent contractors). In doing so, the agents have taken the position that the reduced penalty regime that normally applies under I.R.C. § 3509 when an employer mistakenly fails to withhold income and employment taxes does not apply in these cases to the portion of compensation paid from which no withholding was done. In essence, their reasoning seems to be that under § 3509 only applies in "reclassification" cases, not cases where they are simply "recharacterizing" compensation paid.
I.R.C. § 3509 was originally enacted to provide a bit of a break from paying the full amount of past withholding taxes to employers who accidentally misclassified workers as independent contractors (it's application is excepted in cases where such failure was intentional). While the legislative history is sparse, the Joint Committee on Taxation's report underlying the enactment of the statute clearly indicates that the rule is intended to provide relief against the "significant retroactive tax burden" that can apply to employers in situations where workers are reclassified as employees. However, the statute itself nor the legislative history address any exceptions for situations where this "dual role" issue comes into play. The relevant statutory language is somewhat vague and leaves room for interpretation, stating that "[i]f any employer fails to deduct and withhold any tax under chapter 24 (these are income taxes) or subchapter A of chapter 21 (more commonly known as "FICA" taxes) with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for . . ."
There is no case law that we can find that deals with this "dual role" situation, so we really don't have any instance where a court has interpreted how this language might apply in these types of cases. As stated before, there are also no interpretive regulations issued by the Treasury Department for I.R.C. § 3509, so we're left with a little room here to argue how it SHOULD apply (that's always nice, isn't it?). It seems clear that in cases like this that an employer's failure to withhold these taxes on the compensation paid to Jane or Tom for their secondary, unrelated role was due to "treating such employee as not being an employee," but what does "any" mean? "Any" as in NO tax was withheld AT ALL with regard to that employee, period? As in...ever? Or is "any" here to be interpreted within the context of each separate, distinct role? The IRS Chief Counsel recognizes that such dual roles situations can exist, and have made it clear in the information letter issued that each role should be looked at on its own when determining whether FICA and withholding taxes should apply. Doesn't that cut toward the argument, then, that the penalty relief afforded in normal cases where an employer simply accidentally misclassifies its workers should also apply where those workers have more than just one role? In light of the statutory language's lack of such an exclusion, it seems inequitable for the IRS to take the opposite approach. Of course, it goes without saying that it's also an option in these dual role cases to contest whether such "recharacterization" should apply at all. After all and as discussed, the IRS Chief Counsel has already recognized that such situations can exist, and if so, perhaps the facts support the lack of withholding as to that second role and thus, no penalties - reduced or otherwise - should apply. But as we all know, there's a financial balance that has to be struck between accepting what the examining agent is proposing at the end of the audit, and the cost (and risk) of fighting that down to zero at Appeals and/or in Tax Court. But it sure would be nice if the proposed penalties at that initial stage were in line with what we believe is statutorily required.
And by the way, this professed distinction between "reclassiflying" vs. "recharactizing" being put forward by the IRS that we mentioned earlier? Neither of those words, or any derivative thereof appear in the statute. Surprised? Neither are we.