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Worker Classification Issues and Solutions for Nonprofit Organizations

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Worker Classification Issues and Solutions for Nonprofit Organizations

While nonprofit organizations are exempt from many of the tax issues that face other businesses, the challenges associated with properly classifying workers as employees or independent contractors are the same.  Recent regulations and court decisions are favoring the employer/employee classification.  This classification comes with increased tax related obligations for the employer.  Misclassification of workers can be costly to an organization. 

Why worker classification matters.

Employment classification is critical for federal payroll tax purposes because the employee designation gives rise to employer withholding and contribution obligations while an independent contractor designation does not.  Withheld taxes include federal income tax, Medicare and Social Security tax (FICA), and the Patient Protection and Affordable Care Act (ACA) Medicare surtax on the federal level.  While withholding obligations vary state to state, state withholding for an employee may include state unemployment, disability insurance, and other state sponsored employee welfare programs.  Since all of these withholding taxes can be costly to a business, the IRS, Department of Labor, and similar state organizations are sensitive to the possibility of abuse in worker classification.  As such, there are numerous penalties that an employer can face as punishment for improper classification. 

Who is an employee?

There are many different legal frameworks for determining who is an employee depending on the legal context for the analysis.  Below is a list of some of the different contexts under the law:

  • General federal withholding and payroll tax requirements.
  • Federal and state unemployment tax requirements.
  • Federal labor laws.
  • State labor laws.
  •  Affordable Care Act.
  •  Federal immigration laws.
  •  State income, employment, and disability tax laws.

 

To further complicate matters a worker may be deemed an employee for purposes of one of these statutes but still be considered an independent contractor for another. Since federal withholding and payroll tax tend to have the largest finance impact on nonprofits, this article will solely focus on the definition of an employee in this context. 

The crux of the determination of employee status for federal withholding and payroll tax purposes depends on whether the business has the right to control and direct the worker.  Specifically, the regulations state that an employment relationship exists “when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.”  It is important to note that the employer does not need to actually direct or control how the services are performed, as long as the employer has the right to do so, the worker should be classified as an employee.  There are 20 common law factors that the IRS uses to determine control which can be broken down into three categories; behavioral, financial, and relationship. 

Behavioral control looks at whether there is a right to direct or control how the worker performs the tasks for which he or she was hired. Below is the subset of the 20 common law factors that examine behavioral control.         

  • A worker who is required to comply with other persons’ instructions about when, where, and how to work is ordinarily an employee. 
  • A worker who is trained by the business or some entity affiliated with the business is usually an employee.
  • A worker that performs services that are so integrated in to the business that the continuation or success of the business is dependent on the work is ordinarily an employee.
  • A person is usually an employee if someone else sets their work hours.
  • A worker is usually an employee if the work must be done on the business premises.
  • A worker that has to follow a set sequence or order of tasks is ordinarily an employee.
  • A worker that has to regularly provide written or oral reports is usually an employee.
  • A worker that must work full time is generally an employee.

Financial control looks at whether the worker has control over the business aspects of the worker’s activities. Below is the subset of the 20 common law factors that examine which party has financial control.

  • A worker that is paid by the hour, week, or month is ordinarily an employee.
  • A worker that has his or her business and/or traveling expenses reimbursed is usually an employee.
  • A worker who is supplied with significant tools, materials, and other equipment to perform the job is ordinarily an employee. 
  • A worker that does not have a significant investment in facilities used to carry out the job is usually an employee.
  • A worker that cannot realize a profit or suffer a loss as a result of their services is ordinarily an employee.
  • A worker that is not permitted to provide services to other persons or firms at the same time is generally an employee.
  • A worker that is not available to perform services to the general public on a regular basis is usually an employee.
  • A worker that is not responsible for hiring, supervising and paying assistants is ordinarily an employee.

Relationship of the parties refers to how the parties view each other.  Below is the subset of the 20 common law factors that examine the relationship between the worker and the person for whom services are rendered. 

  • A worker that must personally perform the services is ordinarily an employee.
  • A worker that has had a continuing relationship with the person for whom services are performed is usually an employee.
  • A worker that can be terminated if he or she doesn’t obey instructions is ordinarily an employee.
  • A worker that has the right to end his or her relationship with the person for whom the services are performed at any time without incurring liability indicates that the person is an employee. 

While there are 20 common law factors to look at in determining whether someone is an independent contractor or an employee, the IRS has said that there is no magic number of relevant evidentiary factors.  Instead, IRS agents are instructed to look at all relevant information in making the worker classification determination. 

Risks of misclassification.

In the event a worker is misclassified, an employer is not only liable for the withholding and contribution tax liabilities (as well as interest) but may also be subject to a number of penalties.  An employer that fails to properly classify a worker as an employee could result in penalties for failure to (1) pay the relevant taxes, (2) file a (or file a complete) quarterly federal employment tax return (Form 941), (3) file Form W-2 with the Social Security Administration, (4) give the employee a W-2, and (5) timely deposit withheld taxes. Additionally if the IRS determines that the misclassification was due to negligence or fraud, additional penalties may be imposed.  It is also important to note that the employer is liable for any failure to withhold income taxes even if the employee pays the liability directly when filing his or her tax return. 

Since the IRS could determine that an entity has misclassified its workers during an employment tax audit, it is important to understand how employment tax audits arise.  There are three main ways that an employment tax audit arises.  The first is that the IRS may perform a compliance check of the organization’s Form 941 (Employer’s Quarterly Federal Tax Return).  Based on issues that arise during this compliance check a full employment tax audit may arise.  Similarly, the organization may be subject to an audit of their Form 990.  Usually as part of a 990 audit the IRS will examine employment tax compliance which includes potential worker classification issues.  Third, if the IRS audits an organization’s worker and challenges the worker’s worker classification it could cause the IRS to examine the organization through an employment tax audit. 

If over the course of an audit the IRS reclassifies workers as employees and the organization does not agree it can bring the action to Tax Court.  The advantage of litigating the issue in Tax Court is that the organization does not have to pay the proposed liability in order to file the suit.  In order to bring the matter to District Court, the organization must pay the full proposed liability and then file an action to recoup that money from the IRS.  Since advanced payment is not required for Tax Court, it makes filing a claim more accessible to organizations that may not have the resources to pay the proposed liability.  Additionally, should the nonprofit organization win in Tax Court the organization may be able to recoup attorney’s fees.   

Available relief for worker misclassification issues.

There are four widely used programs for organizations facing worker misclassification issues.  They include the Section 530 Safe Harbor, the Section 3509 reduced rate relief, the IRS Voluntary Classification Settlement Program (VCSP) and the IRS Classification Settlement Program (CSP).  Each program has its own set of requirements. 

Section 530 Safe Harbor

The Section 530 Safe Harbor is available both to organizations that are under audit and organizations that preemptively seek to determine worker status through the Form SS-8.  The Section 530 Safe Harbor has three requirements. First, the organization must consistently treat the relevant worker (and similarly situated workers) as an independent contractor.  Second, the organization must comply with all of the Form 1099 reporting requirements with respect to the compensation paid to the worker for the tax years at issue.  Third, the organization must have a reasonable basis for treating the workers as independent contractors. 

If an organization meets all three of these requirements, the Section 530 Safe Harbor prohibits the IRS from reclassifying workers as employees for federal payroll tax purposes.  It also protects the organization from being liable for employment taxes, penalties and interest for those workers that are covered by the Section 530 Safe Harbor. Additionally, the IRS will not seek to reclassify the status of the workers unless their circumstances change.  Further, should the organization elect to treat the workers as employees in a future period, the Section 530 Safe Harbor prevents the IRS from assessing tax for any prior period. 

Section 3509.

Since the tax liability that an organization can face when a worker reclassification occurs can be large, Congress enacted IRC Section 3509 to help ease the burden.  Under Section 3509, if an organization does not withhold tax with respect to a worker because the worker was classified as an independent contractor rather than an employee, and there was no intentional disregard for the rules, the employer’s tax liability is reduced to 1.5% of the worker’s wages for income tax withholding and 20% of the relevant rate for Social Security tax.  This additionally reduces the amount of penalties that are calculated based on the tax liability such as the failure to file penalty or the failure to pay penalty. 

Voluntary Compliance Settlement Program (VCSP).

If an organization realizes that it has misclassified workers as independent contractors, it can use the VCSP to change the worker’s classification going forward with limited ramifications.  In order to use the VCSP, an organization must file Form 8952, Application for VCSP at least 60 days before the organization starts treating the workers as employees.  If an organization qualifies for the program it only has to pay 10% of the employment tax liability that would have been due on compensation for workers in the most recent tax year.  No interest or penalties would be assessed.   There are three requirements for participation in VCSP.  First, the organization must have treated the workers as independent contractors for the previous three years and filed all required Forms 1099.  Second, the organization must not currently be under an employment tax audit with the IRS.  Third, the organization must not be under a worker classification audit by the Department of Labor or a state governmental agency. 

IRS Classification Settlement Program (CSP).

If an organization under audit does not qualify for the Section 530 Safe Harbor, it may still be eligible to participate in the CSP.  If an organization has timely filed all Forms 1099 for all of its contractors for previous years it is mandatory that the IRS agent present a CSP offer to the organization.  The CSP offer will require the organization to begin treating the workers as employees prospectively.  In return, the IRS will assess employment taxes only for the most recent year and at a discounted rate. 

Best practices for worker classification.

  • Establish and follow written policies for engaging independent contractors and use an independent contractor agreement which both parties sign.
  • Avoid classifying workers that provide similar services differently. If they are providing similar services their classification should be the same.
  • Engage independent contractors that have an established business.
  • Do not restrict the ability of an independent contractor to work for others.
  • Do not provide an independent contractor with an employee handbook.
  • Do not provide business cards, voicemail, or email addresses, to independent contractors.
  • Review your worker classifications annually.  If corrections need to be made, reach out to a tax professional before making changes.  

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