New Rulings Issued on Employee vs. Independent Contractor

[Paul Mayer]

The U.S. Tax Court has issued two new rulings on whether workers should be classified as employees or independent contractors.
The law. In both rulings, the Tax Court said that whether an individual should be classified as an independent contractor or an employee is a question of fact. Common (case) law rules are applied to determine whether an individual is an employee or an independent contractor. In the new rulings, the Tax Court considered the following factors in determining whether workers were employees or independent contractors: (1) the degree of control exercised by the employer; (2) who invested in the work facilities used by the worker; (3) the opportunity of the worker for profit or loss; (4) whether the employer can discharge the worker; (5) whether the work performed is an integral part of the employer's regular business; (6) the permanency of the relationship between the parties; (7) the relationship the parties believed they were creating; and ( 8 ) whether employee benefits were provided to the worker [Reg. § 31.3121(d)-1(c)(2); Reg. § 31.3401(c)-1(b)].

The Tax Court noted that the list of factors above is not exclusive, and other factors may be considered in this analysis.

The rulings. In Keller v. Commissioner, TC Memo 2012-62, 3/8/12, the Tax Court ruled that an auto body shop employer incorrectly classified three of its 10 workers as independent contractors. Two of the three workers performed secretarial duties for the auto body shop (e.g., serving as a receptionist, answering the phones, and filing). The other employee, Eric Mark, started out by cleaning the shop and assisting other workers at the auto body shop, and then moved up to writing estimates for repairs. Mark received on-the-job training from the owner of the company and other technicians at the auto body shop. The three employees were paid weekly by check.

The Tax Court said that the evidence appeared to show that the employer had the right to control the three workers' work, and the employer did not prove that he did not control their work. Accordingly, this factor weighs heavily in favor of employee status for these workers. Other factors that supported a finding of employee status included: (i) the workers did not provide their own equipment; (ii) there was no evidence that the workers had an opportunity for profit or loss; and (iii) the employer could terminate the workers at will.

Section 530 of the Revenue Act of 1978, as amended, provides employers with protection from employment tax assessments even though they incorrectly classified a worker as an independent contractor if they meet the following three requirements: (1) reasonable basis, (2) substantive consistency, and (3) reporting consistency. The employer, however, did not qualify for Section 530 relief because it failed to meet the reporting consistency requirement, as it had not filed Forms 1099-MISC, Miscellaneous Income, for any of the workers in question, which is required under Code Sec. 6041(a) and Code Sec. 6041A(a).

Employment tax penalties. The Tax Court recommended that the employer be subject to employment tax penalties under Code Sec. 6651(a)(1) and Code Sec. 6656(a) for failing to make required employment tax deposits with respect to the three workers who were found to be employees, and to timely remit the tax and file employment tax returns with the IRS.

The Tax Court ruled that the other seven workers should be classified as independent contractors based on its review of the above eight factors.

Second ruling. In Dean Cibotti, et ux. v. Commissioner, TC Summary Opinion 2012-21, 3/6/12, the Tax Court ruled that a mortgage loan officer with Liberty Mortgage, who was also president of the company with a 33.3% ownership interest, should have been classified as an independent contractor, rather than as an employee. The taxpayer, Dean Cibotti, did not perform any services as an officer of Liberty Mortgage, but was named president because he had the largest individual ownership share of the business. The Tax Court based its decision on the fact that: (a) Liberty Mortgage did not have control over or dictate Cibotti's hours of business, total hours, route, office location, or methods of obtaining clients; (b) Cibotti maintained a home office (he didn't have an office at Liberty Mortgage); (c) Cibotti was paid a percentage of the proceeds from the mortgage loans he closed (he was not guaranteed any compensation); and (d) Cibotti was not provided any employee benefits, such as health insurance, life insurance, and retirement plans.

[Paul Mayer]

Employer Owes Taxes and Penalties for Failing to Classify Workers Correctly

The U.S. Tax Court has ruled that an S corporation should have classified two workers as employees, and, as a result, is liable for employment taxes and penalties [Twin Rivers Farm Inc. v. Commissioner, TC Memo 2012-184, 7/2/12].

The facts. Diana Militana was the sole owner and sole corporate officer for an S corporation whose primary activity from Jan. 1, 2006, to Dec. 31, 2008 (the years at issue), was the raising, inventorying, training, marketing, and showing of horses for anticipated sales or leasing. Militana hired two farm workers to work on the property. The workers lived in a trailer on the property and did not appear to ever have paid rent. The workers' job duties included: cleaning stalls, the barn area, the barn offices, the rest room, and the tack room; grooming horses; watering the horses; and moving the horses between pastures.

The law. Whether an individual should be classified as an independent contractor or an employee is a question of fact. Common (case) law rules are applied to determine whether an individual is an employee or an independent contractor.

The ruling. The Tax Court determined that the workers should have been classified as employees, based on its analysis of the factors below.

Degree of control. The court found that this factor supported the existence of an employer-employee relationship between the S corporation and the workers. The court noted that to retain the requisite degree of control, the principal need not actually direct or control the manner in which the services are performed; it is sufficient if the principal has the right to do so. The court said that the nature of the employment arrangement indicates that it was likely that Militana had the right to exercise control, even if that right was not often exercised. The court noted that the workers were allowed to use the S corporation's farm equipment (including a tractor), and concluded that it would be difficult to imagine that the workers' use of the equipment could not have been controlled by the S corporation in the event of misuse by the workers. The court pointed out that Militana was at the farm “most of the time” and, therefore, had the opportunity to supervise the work being done on the farm.

Investment in facilities. The court said that because the S corporation made all of the investments in the equipment supplied to the workers and provided them with everything needed to perform their services, this factor was supportive of the existence of an employer-employee relationship.

Opportunity for profit or loss. The court said that because the S corporation provided the workers with all of the necessary equipment and supplies for the job, the workers had no opportunity to make a profit with respect to the materials used on the job. Given the salary-like nature of the workers' pay ($300 per week) and their lack of entrepreneurial risk or opportunity, the court believed that this factor also was indicative of an employer-employee relationship.

Right to discharge workers. There was no evidence in the record of the existence of any formal or informal agreement or contract that would have precluded the S corporation from discharging the workers. Employers typically have the right to terminate employees at will.

Work is part of principal's regular business. The court believed the workers provided services that were a principal part of the S corporation's regular business, based on the fact that the services kept the farm presentable to potential buyers, kept the grounds safe for the horses, and aided in the care of the S corporation's primary assets.

Permanency of relationship. The court concluded that the workers were long-term employees who actually resided on the farm. It could not be said that the relationship was transitory or temporary.

Relationship the parties thought they created. The S corporation purchased workers' compensation and employer's liability insurance for the years at issue. In addition, the S corporation covered all of the job-related expenses necessary for the workers to perform their duties. The S corporation even provided a residence on the property for the workers and allowed the workers to receive advances on their compensation. The court said that these actions were far more indicative of an intention to create an employment relationship than they were of an intention to create an independent contractor relationship.

Penalties. The Tax Court upheld a failure to timely file required tax returns penalty under Code Sec. 6651(a)(1), because the S corporation submitted no credible evidence that it exercised ordinary business care and prudence in its failure to file Forms 943, Employer's Annual Federal Tax Return for Agricultural Employees, or that it could not file the returns when due. In addition, the Tax Court upheld a failure to make employment tax deposit penalty under Code Sec. 6656, because the S corporation submitted no credible evidence that it exercised ordinary business care and prudence in its failure to deposit employment taxes or that it could not make the deposits when due.