23 TAXES: WHO IS AN EMPLOYEE?
Artists, including graphic design firms, photography studios, and fine artists, frequently hire assistants or other freelancers as needed to bolster the work capacities of any regular staff. Often these additional workers are treated as independent contractors. The advantage of this to the hiring artist is that he or she need only file a Form 1099-MISC at the end of the tax year. However, the IRS would prefer to categorize such additional help as employees. All artists, from designers to photographers to fine artists, must consider whether a part-time helper will prove to be an employee under the IRS standards.
For an employee, the artist must withhold federal, state, and local income taxes; pay half of the tax mandated under the Federal Insurance Contributions Act (for Social Security); pay the full tax required under the Federal Unemployment Tax Act and any state unemployment tax laws; pay for Worker’s Compensation; file a number of returns during the course of the year with the various tax authorities; and provide a W-2 by January 31. The employee will also have rights to any employee benefits, such as health insurance, vacations, holidays, or retirement plans.
Reclassification
If the IRS or state tax authorities reclassify independent contractors as employees, the result can be substantial liabilities not only for the current year but also for earlier tax years “open” to IRS review. A firm that intentionally misclassifies will face the payment of back taxes, penalties, and interest—a total that may be double what should have been paid originally.
Hence, if there are any independent contractors who could be classified as employees, it is far better for the artist to consult with an accountant or tax specialist immediately, rather than face this issue on an audit. If the IRS is successful in reclassifying independent contractors, the very existence of the art business can be threatened.
What Makes an Employee?
The IRS has issued a twenty factor control test (Revenue Ruling 87-41, 1987-1CB296) to clarify the distinction between employees and independent contractors. The control test is easy to state: Is the outside help subject to the control or right to control of the artist? Unfortunately, the guidelines are too general to resolve every situation. Often some factors suggest employee status while others suggest independent contractor status.
Some key factors the IRS looks into include:
(1) Instructions. Is the worker required to obey the artist’s instructions about when, where, and how work is to be performed? If the artist has the right to require compliance with such instructions, the worker is likely to be an employee.
(2) Training. Training a worker suggests that the worker is an employee. The training may be by having an experienced employee labor with the worker, by requiring that the worker attend meetings, by correspondence, or by other methods.
(3) Integration. If a worker’s services are part of an artist’s operations, this suggests that the worker is subject to the artist’s control. This is especially true if the success or continuation of the artist’s business is dependent in a significant way upon the services performed by the worker.
(4) Personal services. If the artist requires that the services be performed in person, this suggests control over an employee.
(5) Use of assistants. If the artist hires, directs, and pays for assistants to the worker, this indicates employee status for the worker. On the other hand, if the worker hires, directs, and pays for his or her assistants, supplies materials, and works under a contract providing that the worker is responsible only for achieving certain results, this would be consistent with being an independent contractor.
(6) Ongoing relationship. If the relationship is ongoing, even if frequent work is done on irregular cycles, the worker is likely to be an employee.
(7) Fixed hours of work. This would suggest that the worker is an employee controlled by the artist.
(8) Full-time work. If the worker is hired on a full time basis, this suggests that the artist controls the time of work and restricts the worker from taking other jobs. This would show employee status.
(9) Work location. If the artist requires that the worker be at the artist’s premises, this suggests employment. The fact that the worker performs the services off premises implies being an independent contractor, especially if an employee would normally have to perform similar services at an employer’s premises.
(10) Work flow. If the worker must conform to the routines, schedules, and patterns established by the artist, this is consistent with being an employee.
(11) Reports. A requirement that reports be submitted, whether oral or written, would suggest employee status.
(12) Manner of payment. Being paid by the hour, week, or month suggests being an employee, while being paid an agreed upon lump sum for a job suggests being an independent contractor.
(13) Payment of expenses. The artist’s payment of expenses implies the right to control expenses and thus suggests employment status.
(14) Providing tools and equipment. If the artist does this, it suggests the worker is an employee.
(15) Investment. If the worker has a significant investment in his or her own equipment, this implies being an independent contractor.
(16) Profit or loss. Having a profit or loss (due to overhead, project costs, and investment in equipment) is consistent with being an independent contractor.
(17) Multiple clients. Working for many clients would suggest the status of an independent contractor, although it may be that the worker is an employee of each of the businesses (especially if there is one service arrangement for all the clients).
(18) Marketing. If the worker markets his or her services to the public on a regular basis, this indicates being an independent contractor.
(19) Right to discharge. If the artist can discharge the worker at any time, this suggests employment. An independent contractor cannot be dismissed (without legal liability) unless he or she fails to meet the contractual specifications.
(20) Right to quit. An employee may quit at any time without liability, but an independent contractor may be liable for failure to perform according to the contractual terms.
A Matter of Intention
The danger is that an artist will either misinterpret these factors or intentionally misclassify a worker as an independent contractor. Since the payment of back taxes, penalties, and interest may be double what should have been paid by the artist, the very life of the artist’s business may be threatened. Also, the IRS may argue that workers with a very peripheral connection to the artist—for example, mechanical artists or even illustrators—are employees. In one case involving state tax authorities, a mechanical artist worked four days for an artist on one project. The artist then filed for unemployment benefits. Not only did the state tax agency determine that the artist was an employee, they also commenced an audit of the artist for three years. The potential liability approached $100,000 and the case took several years to resolve.
The exposure for unintentional misclassification of an employee is serious, but not nearly as serious as the risk for an intentional misclassification. If the misclassification is unintentional, the employer’s liability for income taxes is limited to 1.5 percent of the employee’s wages. The employer’s liability for FICA taxes that should have been paid by the employee would be limited to 20 percent of that amount. The employer would have no right to recover from the employee any amounts determined to be due to the IRS. Also, the employer would still be liable for its own share of FICA or unemployment taxes. Interest and penalties could be assessed by the IRS, but only on the amount of the employer’s liability.
If the misclassification is intentional, on the other hand, the employer can be liable for the full amount of income tax that should have been withheld (with an adjustment if the employee has paid or does pay part of the tax) and for the full amount of both the employer and employee shares for FICA (which might have an offset if the employee paid FICA-self employment taxes). In addition, the employer is liable for interest and penalties. However, the interest and penalties are being computed on far larger amounts than in the case of an unintentional misclassification.
An Ounce of Prevention
After conducting a careful review of how workers should be classified under the IRS’s twenty factor control test, an artist may remain uncertain what is correct. A wise approach is certainly to err on the side of caution and classify workers as employees when in doubt.
If the artist believes a worker to be an independent contractor, a carefully worded contract should be executed with that worker. It should be legally binding and accurately set forth the parties’ agreement. To be most helpful in the event of an IRS challenge, it must be apparent from the contract that the worker is an independent contractor under the twenty factor test. The contract must then be adhered to by the parties. If an artist has such contracts in place already, they should be reviewed with the IRS test in mind—and whether the parties in fact are following the terms of the contract.
Safe Harbors
The tax law also creates certain safe harbors, areas in which artists can know that their classification practices will stand up to IRS review. Taxpayers must have a reasonable basis for their classification decisions. According to the law, a reasonable basis will be found to exist if the taxpayer made a “reasonable reliance on any of the following: (A) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (B) a past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; (C) longstanding recognized practice of a significant segment of the industry in which such individual was engaged;” or (D) reliance upon some other reasonable basis, such as the advice of a business attorney or accountant who is aware of the specific facts surrounding the business.
So the law, as stated in (A), creates a safe harbor if an IRS determination is made as to the worker’s status. If the IRS concluded that a worker was an independent contractor, it would of course be bound by its own determination. While the IRS offices in Washington, D.C., are issuing very few determinations as to status and artists ought not to expect to obtain guidance in this way, the local district offices of the IRS do issue determinations if requested on Form SS-8 with respect to an individual’s status. However, the SS-8 is very specific and may not help as to other employees. And, if the individuals have already been employed, sending in the SS-8 may simply be waving a red flag and asking for an audit. Also, neither judicial precedents nor published rulings are offering clear guidelines for artists to follow.
If the artist has been audited before and no employment tax issues were raised as to a worker performing similar tasks to the worker at issue, this will also provide a safe harbor for the artist. However, not every artist is so fortunate as to fall within this safe harbor.
Further, the artist may argue that its treatment conforms to the long-standing recognized practice of a significant segment of the industry in which such individual was engaged. This is an empirical test that is not necessarily nationwide, but can be by industry and locale. Historical practices are established by evidence that may take the form of surveys, affidavits, and testimony.
Finally, since the IRS may forgive taxpayers who rely on some “reasonable basis” in making the wrong classification, it is extremely important to seek expert advice when in doubt. Relying on the counsel of a business attorney or tax accountant protects business owners from the most serious penalties of an IRS reclassification, provided the attorney or accountant examines specific factual details of the business. Again, an ounce of prevention may preclude a potentially bankrupting audit.
The focus of the IRS on worker classification raises a baffling problem here. If the safest course is to classify workers as employees (even if they might be independent contractors under the twenty factor control test), is the IRS actually forcing the industry to change its practices? And will this change of practice then be used to defeat artists who seek to assert that their practices are consistent with the practices of a significant segment of the industry?
Also, the safe harbor provisions will not be available at all if the artist is inconsistent in his or her treatment of workers. If one worker is treated as an employee and a worker performing similar tasks is treated as an independent contractor for the same period, this inconsistency will deny the taxpayer the protection of the safe harbors. If a worker had been treated as an employee in prior years, but in the audit year was doing substantially the same work while being categorized as an independent contractor, this will also smash the artist’s safe harbor defense on the reefs of inconsistency.
Another important point is that, regardless of a worker’s classification, all required information returns should be filed. The filing of 1099s may aid in arguing that the artist has been consistent in his or her classification practices. Also, the 1099s will encourage tax compliance by the worker, so that the exposure of the artist will be less in the event the IRS successfully reclassifies the worker.
Interns
A related issue can arise with respect to interns. A number of firms in the creative fields have adopted the practice of using unpaid interns who are either college students or recent graduates. The rationale for not paying wages is that the students are having a learning experience. The students discover the shape of the landscape and feel forced to be acquiescent in order to get started in their profession. Of course, if the firm was a nonprofit, such a failure to pay wages might be acceptable because people often work as volunteers for nonprofits. However, such unpaid work for a profit-making firm raises both moral and legal issues.
The Department of Labor gives guidelines in its Field Operations Handbook with respect to whether trainees and student-trainees can be considered not to be employees (in which case no wages would be required). For unpaid interns to be legal, there are six factors that must be met: 1) The training must be similar to that which would be given in a vocational school; 2) The training must be for the benefit of the students; 3) The students must not displace regular employees; 4) The employer must derive no immediate advantages from the activities of students; 5) The students must not be entitled to a job at the end of the training period; and 6) The employer and the student must understand that the student is not entitled to wages.
If the internship does not meet these criteria, then the intern is an employee and subject to minimum wage laws and payroll withholding requirements. The failure to pay minimum wages and withhold properly can violate both state and federal laws and subject the employing firm to substantial liability in the event the employment is discovered by the authorities.
In addition, from a moral standpoint, it is wrong to take the benefit of someone’s labor without paying wages. We hardly have to refer to The Communist Manifesto to understand that if the intern’s work gives value to the employer, then it should be paid for. The fact that students are desperate to get the experience that will allow them to enter their chosen professional field is no reason to take advantage of them. Since hardly any intern fails to do some work of value for his or her employer, unpaid internships should really be the rare exception (perhaps permissible only if course credit is being received by the student) and certainly not the rule.