For years, the question of whether construction workers should be treated as employees or independent contractors has been an important issue that many contractors have overlooked or chosen to ignore. However, a recent U.S. Tax Court decision highlights the need for construction contractors to focus on how they classify their workers for employment tax purposes.
The taxpayer in Kurek v. Commissioner, T.C. Memo 2013-64 (Feb. 28, 2013), was a sole proprietor who worked as the general contractor in renovating home interiors. During the tax year at issue, the taxpayer hired approximately 30 workers to assist him on various home renovation jobs. None of the workers worked full time for the taxpayer, and he paid them on a project-by-project basis. He paid each worker a weekly flat fee based on the percentage of work completed on a particular job. The workers set their own hours and work schedules. The taxpayer supervised the workers’ progress on a project and was at the worksite once a day or once every other day. Although the taxpayer permitted the workers to work simultaneously on other projects with him or with other construction groups, he would replace workers if a deadline was approaching or if a worker was holding up a job.
The workers brought their own sets of small tools, worth around $1,000, to the worksites. The taxpayer did not reimburse the workers for those tools, but he did buy or rent all larger tools, which he left at the worksites. Petitioner purchased materials needed for the projects, and the homeowners would reimburse him. Occasionally, workers purchased lightweight materials as needed during the project, and petitioner would reimburse them.
The taxpayer did not offer any employee benefits nor did the workers sign an independent contractor agreement. He did not carry unemployment insurance or workers' compensation insurance for the workers. Most importantly, the taxpayer did not issue Forms 1099-MISC or Forms W-2 to any of the workers for the tax year at issue. Following an employment tax audit, the IRS determined that the workers were the taxpayer’s employees and that he should have paid Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes, as well as income tax withholdings on the workers’ wages. The taxpayer appealed the IRS’s determination to the U.S. Tax Court.
Whether a worker is an employee or an independent contractor is a factual question to which common law (judge-made) principles apply. In short, the right of the principal to exercise control over the agent, whether or not the principal in fact does so, is the “crucial test” for the existence of an employer-employee relationship. Under the common law, an employer-employee relationship exists when the principal has the right to control and direct the service provider regarding the result and how the result is to be accomplished. The principal need not actually direct or control the manner in which the services are performed; the principal need only have the right to do so.
Despite the presence of several factors in favor of independent contractor status, the Tax Court concluded that the workers should be classified as the taxpayer’s employees because the taxpayer failed to prove that he did not have control over the workers. Although the workers set their own hours and provided their own small tools, the taxpayer set deadlines and monitored their work, visiting the worksite daily or every other day. The Tax Court found it important that the taxpayer: (1) had the ultimate authority in instructing the workers as to their job responsibilities, (2) had the right to approve the quality of their work, and (3) paid them weekly rather than at the end of the project. Moreover, only the taxpayer communicated with the homeowners, and he alone was responsible for the success or failure of the projects. The Court also held that the taxpayer did not qualify for alternate relief otherwise available under Section 530 because he did not file Forms 1099 for any of the workers, which is a critical element of that statutory safe harbor.
If you have any questions regarding this case or how the law may apply to your business operations, please contact one of the authors.
IRS Expands Voluntary Worker Classification Program
The IRS recently announced that it has expanded its Voluntary Classification Settlement Program (VCSP) to allow more taxpayers to reclassify their workers as employees for future tax periods. The VCSP offers substantial relief from federal payroll taxes to eligible employers who have been treating their workers (or a class or group of workers) as independent contractors or otherwise as nonemployees and now wish to begin treating them as employees. It does not affect state payroll tax, state unemployment insurance (SUI) tax, or workers’ comp obligations.
Under the expanded program, employers under IRS audit (other than an employment tax audit) can still qualify for the VCSP. To be eligible to participate in the VCSP, an employer must currently be treating the workers as nonemployees; consistently have treated the workers in the past as nonemployees, including having filed any required Forms 1099 (see below for a special limited-time exception to this requirement); and not be currently under audit on payroll tax issues by the IRS or on worker classification issues by the Department of Labor or a state agency.
Normally, employers are barred from the VCSP if they failed for the past three years to file required Forms 1099 for the workers they are seeking to reclassify. However, the IRS is waiving this eligibility requirement for taxpayers who come forward before June 30, 2013. Contractors not previously eligible for the VCSP due to their failure to file Forms 1099 should decide quickly whether to take advantage of this brief window of opportunity to clean up their worker classification practices before they find themselves in the same boat as the GC in Kurek.
Employers can apply for the program by filing Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees. Employers accepted into the program will generally pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years.
Employers accepted into the program no longer will be subject to a special six-year statute of limitations on such reclassifications; instead, they will come under the three-year statute that usually applies to payroll taxes. Employers that failed to file Forms 1099 may also apply for the temporary relief program, but they likely will pay a slightly higher amount (including some penalties) and will need to file any unfiled Forms 1099 for the workers they are seeking to reclassify as employees.
If you have any questions regarding worker classification issues, or if you are interested in participating in the IRS VCSP, feel free to contact Bruce Ely, Stuart Frentz, or Will Thistle of our Tax Practice Group.