Is that Worker an Employee? Questions and Answers on Worker Classification.

Is That Worker An Employee?
Questions & Answers on Worker
Classification
Michael DeBlis III, Esq.
Partner
DeBlis Law

Michael DeBlis III, Esq.
• Trial Lawyer
• Actor
• Author
• Marathon runner

Introduction
• The cost of paying human capital is among the
largest burdens for most businesses. For good
companies that value quality employees, this
is a solid investment – after all, strong workers
can make or break a business. For their less-
scrupulous peers, however, paying for
employees is an obnoxious pain that simply
stands in the way of more necessary spending.

Introduction
• This disdain for covering employee costs has,
over time, developed into a startling and
unfortunate trend: employee
misclassification.

Introduction
• A W-2 employee costs a company quite a lot.
In many jurisdictions, there are requirements
related to benefits and paid vacation time,
and employers are required to pay a portion
of employee tax obligations.

Introduction
• An independent contractor, however, doesn't
come with any of these costs. Benefits aren't
required, vacation time is rarely provided, and
the employee pays all of his own taxes. Win-
win, right?

Introduction
• Wrong. Employee classification isn't just a
whim left up to an employer; it's based on
federal laws that cover aspects of a work
environment like scheduling and control over
assignments.

Statistics
• Despite this, many employers continue to
misclassify employees for personal gain – a
2000 study found that 10% to 30% of
employers have misclassified workers. Further,
the same study found that 95% of workers
who believed they were misclassified were,
indeed, improperly categorized.

Statistics
• Additional examinations have indicated that
current rates of misclassification may be even
higher than previously suspected
• In Ohio, misclassifications increased by 53.3%
from 2008 to 2009, while Illinois reported an
increase of 21% from 2001 to 2005.

Statistics
• These statistics paint a dire picture, but the
government is adamant that they are cracking
down on this alarming trend.
• In 2011, the Department of Labor collected
over $5,000,000 in back wages for 7,800
employees.

The Skinny
• If you think you may be misclassified, or have
a client that is misclassified, here's what you
need to know – and what you can do about it.

The Importance of Proper
Classification
• Income tax, Social Security, FICA, and FUTA are
among the irrefutable realities of paying
employees or earning wages. All W-2 employees
are required to have these amounts withheld
from their paychecks – but the same is not true
for independent contractors.
• While this amount varies from one state to
another, this can result in 20% or more of an
employees' paycheck in withholdings each
payday.

Trust Fund Taxes
• The IRC requires payors to withhold for taxes
amounts paid to certain individuals.
• The most commonly encountered example is
where an employer must withhold from an
employee’s wages the employee’s federal
income taxes and the employee’s share of
FICA taxes.

Trust Fund Taxes
• The withheld taxes are referred to as “trust
fund” taxes.
• The theory is that the employer has “paid
those amounts to the employee so that the
employer is no longer entitled to the amounts
and, by retaining the amounts, holds them in
trust for the government until they are paid
over to the government to be applied to the
employee’s tax accounts.”

Trust Fund Taxes
• Even though the funds are designated “trust”
funds, there is no requirement that after
withholding and prior to remitting to the
government, that the funds actually be held in
some type of segregated trust fund or
account.

Trust Fund Taxes
• Prior to being turned over to the government,
the employer holds the funds and can use
them for any purpose whatsoever, although
the person or persons directing their use for
purposes other than payment of the trust fund
tax can be liable for this TFRP or even a
collateral criminal penalty (S 7202).

Trust Fund Taxes
• The government must credit the employee
with the amount withheld even if the
employer does not remit the withheld
amounts to the IRS.

Trust Fund Taxes
• The following is a good example of the courts’
view of the trust fund tax and the employer’s
responsibility:
– The withholding taxes “are part of the wages of the
employee, held by the employer in trust for the
government”; the employer, as a function of
administrative convenience, extracts money from a
worker’s paycheck and briefly holds that money
before forwarding it to the IRS. **** A delinquency in
trust fund taxes thus is not simply a matter between
the IRS and an employer, but rather involves
employee wages.

Trust Fund Taxes
– The significant responsibility *** is summed up by
then-Judge Cardozo’s famous statement that “[a]
trustee is held to something stricter than the
morals of the market place. Not honestly alone,
but the punctilio of an honor the most sensitive, is
then the standard of behavior.”

Trust Fund Taxes
• Here is an example:
– Employer owes Employee $ 500 for wages and, based
upon the withholding requirements, must withhold $
50 for the employee’s income taxes (based on the
employee’s W-4 and the related withholding tables)
and $37.50 for the employee’s share of FICA.
Employer writes a check to Employee for $ 412.50 ($
500 - $ 87.50). Employer is deemed to have withheld
the $ 87.50 from the payment and is required to turn
that over to the IRS. It does not matter whether or not
Employer in fact withheld. Indeed, Employer may have
only had $ 412.50 to pay the employee and that’s all
he paid. Nevertheless, Employer is deemed to have
withheld the $ 87.50.

Trust Fund Taxes
– The employer is liable for the $ 87.50. Failure to pay
over the $ 87.50 to the IRS subjects the person or
persons within the employer’s organization
responsible for the failure to do so to the trust fund
recovery penalty (TFRP). When the employer fails to
pay the trust fund taxes, it will usually also fail to pay
the employer’s related taxes – specifically, the
employer’s portion of FICA. However, the employer’s
portion is not a trust fund tax. In other words, it’s not
another person’s liability which is satisfied through
withholding.

Trust Fund Taxes
• In this example, even if the withheld taxes are
not paid, the employee will be credited
against his income tax and credit for payments
into the social security system for FICA.
Essentially, the employer is the withholding
agent for the government.

Trust Fund Taxes
• Not surprisingly, given the amount of dollars
in the system for trust fund taxes, the IRS has
a vested interest in encouraging compliance
with requirements for withholding and paying
over to the IRS.
• As such, the IRS has major compliance
functions in place to deal with potentially
delinquent withholders.

Trust Fund Recovery Penalty
• Section 6672 imposes civil liability upon
certain persons other than the employer for
unpaid trust fund taxes.
• The Code refers to the liability as a “penalty,”
but it is merely a tool to enforce collection of
the trust fund taxes.

• Although the liability is related to the
underlying trust fund taxes, it is still a liability
separate and apart from them.
• The liability is frequently referred to as the
Trust Fund Recovery Penalty (TFRP).

• The circumstances giving rise to the penalty is
that the employer is late in turning over the
trust fund taxes to the IRS and then is unable
to pay them.
• When a business falls on hard times and is
experiencing cash flow problems, the principal
person or persons managing the business may
attempt to keep the business afloat by using
the trust fund taxes to satisfy what he
perceives to be a far more urgent need.

• The expectation is that the cash flow problem
will disappear and that the trust fund tax will
be paid later.

• The withholding taxpayer often views his
intervening use of the trust fund tax proceeds
as a temporary fix to get through a “rough
time,” with every intention of eventually
paying it.
• If the business succeeds or the withholding TP
otherwise pays the delinquent taxes (with
interest on the delinquent payments),
everybody lives happily ever after.

• But if the business goes belly up with the IRS
holding the bag, as is too often the case,
things go south fast.
• Section 6672 imposes civil liability – the TFRP
– for the unpaid trust fund taxes upon those
individuals who had the responsibility to
ensure that the withheld taxes were paid over
to the government for the trust fund taxes
instead of being used for other purposes.

• An individual is subject to the TFRP if he:
– Was “required to collect, truthfully account for,
and pay over,” and
– Willfully failed to do so.
• The statute refers to the liability as a penalty
but it is actually just a secondary tax collection
mechanism for employers who fail to remit
the withheld taxes to the IRS.

• A person who is subject to the TFRP may have
direct liability for the trust fund tax, as well as
other taxes of the employer.
• Under most states’ general partnership laws, a
partner in a partnership is generally liable for
the trust fund taxes as general partners
separate and apart from the TFRP and
assessing the TFRP might be unnecessary.

Classification
• Why is this significant? In 2011, the
Department of the Treasury estimated that
every employee misclassified as an
independent contractor saves a company
nearly $4,000 in employment taxes and
$43,007 in salaries and wages.

Classification
• This trend has likely only risen after the
Affordable Care Act was phased in. As
employers meeting specific regulations are
required to provide insurance for their
employees, this only adds to the expenses
accrued to keep people on the payroll.

Classification
• Employers benefit when misclassifying, but
the opposite is true for employees.

Classification
• In addition to an increased tax burden,
independent contractors also lose the benefits
associated with employment, such as:
– Unemployment insurance;
– Worker's compensation for injuries;
– Minimum wage and overtime protections;
– Coverage under FMLA; and
– The safeguards of employment equality laws, like
the Age Discrimination in Employment Act and the
Civil Rights Act.

Classification
• Law-abiding businesses are hurt by the
negligence of others, as well.

Classification
• One study found that
misclassifying employees can increase the
costs of unemployment taxes and workers'
compensation premiums based on the
adjustment of participants in the general pool.

Classification
• Part of the costs associated with employee
benefits may shift to the general public, too
• For example, underpaid contractors not
eligible for insurance at work may opt instead
for public assistance.
• And while seemingly insignificant, businesses
that save money through illegal classifications
gain a competitive advantage, too

Employees vs. Contractors
• Under the law, there are four available
employment classifications:
–Independent contractor,
–Common-law employee,
–Statutory employee, and
–Statutory non-employee.

• While there are similarities and differences in
all of these categories, the major difference
separating employees from contractors is the
element of control.
• An employer has the ability to dictate the
work to be done, who should be doing it, how
it is to be done, and what the end result
should be.

• This means that if an employer tells you that
you personally must prepare a sales report
using the data included in your sales reporting
systems to be completed fully and accurately
by the end of the workday, this is completely
and fully his right.
• As long as this direction or element of control
is present, an employee-employer relationship
exists, even if one or both parties wish to
classify this relationship as something else.

• A contract or other signed agreement does
NOT have the power to supersede the law.
• This is what’s known as the “substance over
form doctrine.”
• Time for a slight digression to expand on this
doctrine.

• The “substance over form
doctrine” maintains that the “substance,”
rather than the form, of a transaction is what
governs the tax consequences of a
transaction.
• Generally, the effect of applying the doctrine
is to produce a tax result that differs from the
tax result that its form would otherwise
demand.

• The substance over form doctrine arose from
the Supreme Court case Gregory v. Helvering,
293 U.S. 465 (1935), where the Court held
that, “as a general rule, the incident of
taxation depends on the substance rather
than form of the transaction.”

• Since that 1935 case, various courts have
disallowed a tax benefit associated with a
transaction that has a form that differs from
its substance.
• Historically, the government has relied on this
doctrine to target schemes where taxpayers
have intentionally mischaracterized a
transaction in order to derive beneficial tax
treatment.

• Should the shoe be on the other foot and the
worker himself be given the right to direct and
control the work to be done, the hours during
which work can be completed, and who
physically performs the work, these aspects
are far more indicative of an independent
contractor role.

• What this means: An employer can offer a
project to a contractor, so long as the terms
on which the project is completed are
controlled primarily by the contractor, not the
employer.

• In order to make this boundary a little clearer,
the IRS published 20 factors, weighed in terms
of their importance and applicability, that can
be used to help businesses and workers
understand where they stand.

• In general, if the answer to most or all of these
questions is "yes," the worker is an employee.
• If most or all of these questions can be
answered with "no," the employee can likely
be classified as an independent contractor.

• The main points are:
– Is the worker required to follow instructions
regarding where, when, and how he is supposed
to work?
– Is the worker provided with training prior to
beginning work, like meetings, seminars, or other
correspondence?
– Are the services offered by a worker integral to
business operations and ongoing business
success?

–Must any services be personally provided?
–Are any assistants hired, supervised, and
paid?
–Is there an ongoing relationship between
the hiring body and worker?
–Does the service consumer set duty or work
hours?

–Is the time committed by the worker
performing services roughly equivalent to
full-time hours?
–Is work performed on the premises of the
service consumer? (While plenty of workers
do perform work at third-party sites and
can still be considered employees, offsite
work often suggests greater freedom. The
applicability of this point will largely depend
on the work being performed.)

– Must services or jobs be performed in a set order
or sequence?
– Are oral or written progress reports required in
the course of performing tasks?
– Is the worker being paid on an hourly, weekly, or
monthly basis, versus a lump sum or commission
payment?
– Are business travel expenses covered by the
service consumer?

–Is the worker provided with significant tools
and resources to complete work, like a
computer or mobile phone?
–Does the service consumer invest in
maintaining a workspace for the worker?
–Does the worker have any protection from
liability in regards to the realization of profit
or loss from his services, separate from the
general liability that exists as an employee?

– Does the worker provide services for a single
service consumer at a time, rather than piecework
for multiple parties? (Note that it is possible for
workers to be employees of more than one
company simultaneously, and that has no bearing
on worker classification.)
– Are any services offered by the worker not
available to the general public?

– Does the service consumer have the ability to
release or discharge the worker?
– Is the worker able to terminate his labor
agreement at any time without consequence?

• Note that most service consumer-worker
relationships in the U.S. are more
appropriately categorized as employee-
employer connections.

• Due to the explicit nature of these questions
and the subsequent lack of confusion
associated with correct employee
classification, misclassification lawsuits are on
the rise – and progress has been seen.

• FedEx, the international shipping carrier, was
the subject of one of these cases. The
outcome?

• 2,300 workers previously considered
independent contractors were found to be
misclassified.
• FedEx argued that the drivers provide their own
trucks and didn't have to follow specific
routes, but the court determined that by
dictating hours, uniforms to be worn, and
mandatory company-provided training, FedEx
was exerting control inappropriate for
contractors.

• In this case, the court made clear that
absolute control isn't required for employee
classification, just a certain amount above and
beyond what would be expected of an
independent contractor.

Employees by Statute
• In some cases, a worker may still be
considered an employee by title alone, even if
the control test questions demonstrate
otherwise.

• These roles include:
–Officers of corporations as well as
superintendents, managers, and other
supervisory personnel (note that corporate
directors are not generally considered
employees for their directorial duties)

–Statutory employees, including drivers
engaged in food service distribution,
employees who work from home according
to an employer's specifications, and full-
time traveling or city salesmen.

–FICA taxes must be withheld from statutory
employees if:
• The majority of services must be
provided by the worker in question;
• The worker doesn't have a substantial
investment in the tools and facilities
required to satisfy tasks; and
• Tasks are a part of an ongoing
relationship.

–Section 218 agreements, or workers of the
state or local government covered by
Section 218 of the Social Security Act.

• While statutory employees are considered
employees, statutory non-employees are not.

• Workers who fit into this classification include
–Real estate agents who operate
independently and make most income on
commission,
–Direct sellers, and
–Companion caregivers not employed by a
parent company.

Suspected Misclassification
• If you're reading this and thinking “well, this
isn't good,” either in regards to yourself or a
client, there are steps that can be taken to
right previous wrongs.

• First, it is suggested that those who believe
they are improperly classified to first speak
candidly with their employer. In some cases,
employers do not mean to misclassify workers
are not malicious about their practices, and
truly do not realize the issues at hand.

• However, this step should be taken on a case-
by-case basis, and workers concerned about
job security may not be ready to come
forward.

• The next step is to get the government
involved. By filing Form SS-8, Determination of
Worker Status for Purposes of Federal
Employment Taxes and Income Tax
Withholding, workers can request a
determination by the IRS.

• This form outlines many of the same
principles listed above, and even takes things
a step further, categorizing forms of support
into three distinct buckets:

– Behavioral Control: The presence of rules
regarding scheduling, training, tools, equipment,
and work performance
– Financial Control: Issues concerning who pays
workers’ expenses, like workspaces and
equipment, and how workers are paid (lump sum
vs. a standard paycheck)
– The relationship between the service consumer
and worker: The presence of advantages like
benefits or restrictions like non-compete or non-
disclosure agreements

• Upon receipt of Form SS-8 from a worker, the
IRS will then send the same form to the
service consumer to be completed.

• The case will be assigned a technician, who
will review both Forms and determine a ruling
based on the law.
• If a formal determination is issued by the IRS,
it is considered binding for all future cases
with the same set of facts.
• If an information letter is sent, this is not
binding but rather can be interpreted as
advisory.

• Note that the statute of limitations for a
refund continues to run during this time,
regardless of the preparation of Form SS-8.

• If a taxpayer is concerned about this, he is
encouraged to file Form 1040X, an amended
return, as soon as possible with the words
"Protective Claim" at the top and, under Part
III, Explanation of Changes, "Filed Form SS-8
with the Internal Revenue Service Office
in Holtsville, NY. By filing this protective claim,
I reserve the right to file a claim for any refund
that may be due after a determination of my
employment tax status has been completed."

How a Worker Should Handle an IRS
Determination of Worker Misclassification
• While it's possible to give the IRS a heads up
via Form SS-8, it's far more likely for the IRS to
note misclassification through a standard
business audit.

• One of the biggest red flags the IRS looks for –
and something that can actually trigger an
audit – is a substantial number of 1099-
MISCs with large numbers in Box 7 (Non-
employee compensation).

• For those found to be miscategorized who
have not yet filed taxes, the amount reported
on Form 1099 should be included on Line 7 of
Form 1040.

• FICA tax must then be calculated manually
using Form 8919, Uncollected Social Security
and Medicare Tax on Wages.
• Further, the taxpayer should include Form
4852, Substitute for Form W-2, Wage and Tax
Statement, to stand in for the W-2 that should
have been provided.

• If taxes were already filed, Form 1040X will be
required to amend the original filing and
request a refund of any self-employment tax
paid.
• If a W-2 is eventually offered, an additional
amendment may be suggested.

• As FICA taxes are jointly paid, employers who
are working to change poor practices should
request employees fill out Form
4669, Statement of Payments Received, to
account for the portion a worker paid on his
own behalf.

• In some rare and unfortunate circumstances, a
change in classification may result in a
deficiency if a worker was taking deductions
on Schedules A or C that aren't permitted for a
W-2 employee to claim. There is no relief for
workers in misclassification cases, so these
changes will require an amended return and
further payment.

Suing the Employer for Additional
Penalties
• So, you were illegally misclassified and you're
mad about it. Now what?

Penalties
• In some cases, a lawsuit may be the
appropriate response. Under Section 7434,
there may be recourse for the victims of those
who knowingly file a fraudulent information
return.

Penalties
• Damages can range from $5,000 to the true
value of the damage that resulted from the
changes in filing status, as well as the cost of
bringing legal action, including reasonable
legal fees.

Penalties
• To win this kind of case, you must be able
to prove that:
–An information return (like a 1099-
MISC) was issued
–This return was fraudulent
–The return was issued willingly and
knowingly

Penalties
• A good faith belief that correct measures were
taken will remove the scent of fraud, but a
lack thereof can qualify. There is a time limit
on Section 7434 – six years from the date the
return is first filed or one year after the
fraudulent return would have been identified
through reasonable care – but the IRS has no
set limit to bring charges against an employer.

Whistleblower Awards
• The IRS has a long history of
rewarding whistleblowers who help with the
identification of tax fraud, and employee
misclassification is no different.
• Under Section 7623, rewards may be available
for those who provide actionable tips on
employee miscategorization.

• Should the IRS determine that any tips
provided contribute to judicial or
administrative action, the whistleblower may
be eligible to receive 10% to 30% of collected
proceeds.

• Anyone submitting information that could
result in a reward should file Form
211, Application for Award of Original
information.
• If the case is personal, this can be included
with Form SS-8.

The Ignorance Defense
• “But we didn't think we were doing anything
wrong!”

• It's a common defense for companies
classifying workers incorrectly, and in many
cases it's true – or, it was true, at one point or
another.
• While some businesses certainly do set out to
defraud the government, most had misguided
albeit good faith reasons to begin to
misclassify workers in the first place.

• Those who really and truly did not mean to
escape the law have protection under Section
530 of the Revenue Act of 1978, which
safeguards those who made an honest
mistake in worker classification.

• To qualify for this protection, the following
must be true:
–A reasonable basis for treating employees
as contractors, like similar and frequent
behavior elsewhere in the industry
–Consistency in classification among all
workers in a similar position
–Reporting consistency

Classification Settlement Program
• While relief is available under Section 530, the
IRS also offers a Classification Settlement
Program, or CSP, to ease the burden. This
allows the IRS to support those with potential
misclassification issues early in the
administrative process to avoid the possibility
of appeals or litigation. In some cases, the IRS
must offer the option of a CSP for taxpayers to
reject or accept.

• In the CSP process, the IRS will first determine
if misclassification applies, as well as if Section
530 relief is appropriate.

• If any basis for miscategorization is found and
all 1099 paperwork was filed in accordance
with the law, the IRS may offer an adjustment
equal to 25% of any deficiency in the most
recent tax year under investigation.

• If there appears to be no sound reasoning for
classification and none of the requirements
under Section 530 are met, the service
consumer must pay 100% of the adjusted
amount for the most recent tax year.
• In both of these situations, employers must be
willing to reclassify their employees.

• CSP participation is optional, and service
consumers have the right to an Appeal or
administrative review.

Voluntary Classification Settlement
Program
• An alternative to the traditional CSP program,
the Voluntary Classification Settlement
Program is an option for those who voluntarily
come forward to report potential
misclassification before the IRS or Department
of Labor can intervene.

Program
• The VCSP is a big incentive for those who
haven't been targeted yet; through VCSP,
companies are permitted to reduce their tax
liabilities to just over 1% of the wages paid to
reclassified workers while abating all penalties
and interest.

Program
• Further, successful program completion can
preclude audits for unpaid employment tax in
past years.

Requesting a Tax Court Determination
• When a Section 530 defense isn't an option
and a CSP is rejected, a tax court
determination under Section 7436 might be
an alternate pathway to consider.

• Section 7436 allows the U.S. Tax Court to
determine employment tax issues including
misclassification, as well as the calculation
of FICA, FUTA, and income tax.
• Section 7436 is only for service consumers;
workers are NOT able to argue status.

• A Section 7436 filing doesn't have to be the
first step; service consumers can start by
seeking an Appeal.
• In this process, the IRS will first send Letter
950-C, Employment Tax 30 Day Letter-WC, a
notice of adjustment to employment taxes.

• This can be accompanied by Form
13683, Statement of Disputed Issues, for
adjustments less than $25,000.

• Upon receipt, an employer can then submit a
letter to Appeals with a statement of any
disputed adjustments as well as the
background details and explanations to
support these assertions.
• After this, the employer will have a chance to
meet with an examiner before proceeding to
Appeals.

• If no response is filed within 30 days or if the
IRS Appeals process goes awry, the IRS will
likely respond with Letter 3523, Notice of
Determination of Worker Classification
(NDWC), indicating the misclassified
employees that need to be recategorized.

• If a service consumer would still like to fight
back, he has until the 91st day following the
postmark date on the NDWC to petition the
Tax Court.

• However, things may not get better in Tax Court; similar
to the 20-factor test used by the IRS, the Tax Court uses a
seven-factor test to determine employee classifications.
– The degree of control by the service consumer
– The source of facilities funding
– The opportunity for profit or loss
– The ability to discharge a worker
– Whether the work being performed is a part of the
service consumer's regular business
– The permanence of the relationship
– The relationship the parties believed they were
entering into

• If the amount being disputed is under $50,000
for each quarter, the taxpayer may be better
positioned to conduct a judicial review as an S
case, or a small claims case that falls under
the umbrella of Section 7436.

• These cases are smaller and less expensive,
but there's no arguing with the ruling: both
sides forfeit the right to additional appeals by
proceeding with an S case.

The Bottom Line on Classifications
• Employee misclassification steals billions of
dollars from the government every year and
hurts countless good employees just trying to
earn an honest living.

The Bottom Line on Classifications
• The best situation for everyone – except,
perhaps, for unscrupulous employers who
plan to go on being unscrupulous, laws be
damned – is to classify employees properly
the first time around, and to stay up to date
on rulings to be sure things don't change to
the detriment of you, your clients, or even
your company.

Tel. 973.783.7000
MJDeBlis@DeBlisLaw.com
www.DeBlisLaw.com

Is that Worker an Employee? Questions and Answers on Worker Classification.

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