An employee is an individual who performs a service for the university/agency and is working under the direction and control of the university/agency or its employees. Direction and control can be implied to exist when the employer has the right to control both the results as well as the means and methods of the worker. (IRS Treasury Regulation 31.3121(d)-1(c)).
An independent contractor is an individual engaged by the university/agency to perform a specific function or task and who is free to perform this function or task completely at the individual’s own discretion with regard to means and methods. No taxes are required to be withheld or paid on compensation disbursed. (IRS Treasury Regulation 31.3401(c)-1(b). The existence of an agreement or contract helps support the independent contractor position. This document should be fairly specific in what is to be provided and amount or lack of control the university/agency has over the individual.
1.2 Factors Distinguishing Employee Status from Independent Contractor Status
Specific factors that are used by the IRS in determining whether an individual is an employee or an independent contractor are listed below. This listing is commonly referred to as the “20 factors” test.
- Worker is required to comply with instructions about when, where, and how work is done.
- Worker needs to be trained.
- Worker’s tasks are integrated into normal business operations.
- Worker’s services must be personally rendered.
- Worker is not responsible for hiring, paying, or supervising assistants.
- Worker has continuing relationship with “employer”.
- Working hours are set by “employer”.
- Worker is required to devote full-time efforts to “employer’s” business.
- Worker must perform or execute duties on “employer’s” premises.
- Worker’s services must conform to order or sequence set by “employer”.
- Worker is required to submit regular oral or written reports.
- Worker’s payment is based on time spent instead of by the job.
- Worker is reimbursed for travel and other expenses.
- Worker is furnished tools, materials, and other equipment by “employer”.
- Worker has no significant investment in facilities (such as an office).
- Worker has no risk of real economic loss.
- Worker is not working for more than one “employer” at a time.
- Worker does not make services available to the general public.
- Worker is subject to discharge without “employer” penalty — even if job specifications are met.
- Worker can terminate relationship with “employer” without worker liability.
Note: “Yes” answers are indicative of employee status per IRS Revenue Ruling 87-41, 1987-1 CB 296.
While there is no set number of “yes” answers which cause a person to become an employee rather than an independent contractor, some IRS auditors will try to classify an individual to employee status with only one yes. If you have more than a few “yes” answers, extreme caution should be taken if independent contractor status is going to be claimed.
Of cautionary note was a recent private letter ruling, PLR 9825009, issued by the IRS in which a nurse was determined to be an employee rather than an independent contractor. The nurse worked for a government entity in a clinic and was contracted to the clinic by a personnel-placement service. The IRS noted that highly skilled professional workers perform their services with limited control and instruction and, therefore, can be classified as employees though minimal control is exercised over their working arrangements. The IRS held that the government entity was the common-law employer for federal employment taxes, but the placement service was responsible for FICA, FUTA, and federal income tax withholding as it controlled the nurse’s wages. This letter ruling is mentioned to heed caution to the importance of proper evaluation and documentation in regards to employee vs. independent contractor. Note: Private letter rulings are intended only for the entity requesting the ruling.
A recent court case (Consolidated Flooring Services vs. Commissioner) determined that an independent contractor’s helpers became the employees of the company when wages were disbursed by the company. This result was created by IRC Section 3401(d)(1), which provides that if the employer for whom services are performed does not control payment of wages to the employee, whoever does have “control of the payment of the wages” is treated as the employer. Thus the university/agency should not pay the wages of the helpers of their independent contractor’s. If this occurs, the university/agency should include these individuals as employees.
IRS auditors have examined enough abuses of the existing employment tax rules occurring in tax exempt organizations to have become sensitized to situations that are unique to higher education. Specifically, the IRS will be scrutinizing payments that are made to the following individuals:
- “adjunct” faculty and part-time instructors; TAM 9105007 concluded that part-time professors were employees of the college because of the elements of control existing in the relationship between the college and the professors.
- outside contract payments to coaches;
- agricultural laborers performing temporary work;
- instructors in non-degree professional development programs;
- “consultants” or other “independent contractors” who perform management or supervisory functions for the institution;
- graduate research assistants and fellows; Teaching/research assistants and graduate assistants (non-teaching) are defined as being assigned to specific duties by a principal investigator or project leader. The employer’s legal right to control both the method and the result of the service causes these individuals to be considered employees by definition.
- individuals with excessively low withholding;
- independent contractors paid more than $5,000 in a calendar year;
- nonresident aliens paid as employees, independent contractors, or who receive fellowship or scholarship grants;
- early retirement options; and Payments to induce professors to give up tenure and retire early are wages subject to FICA and federal income tax withholding purposes. (IRS Letter Ruling 9711001). Tenure, and the rights associated with this status, are awarded to probationary appointees as a consequence of their past service to the university. Since these payments are made to cancel tenure rights that relate to past services, rather than to cancel a contract right, they are includable in taxable wages.
- “dual-status” workers (those considered both an employee and a contractor). In some circumstances, an employee may have an outside professional corporation that performs the contracted service and payment is being requested from the corporation. A basic question needs to be asked at this point – who is being hired? The individual through their corporation or the corporation itself? If the individual is simply requesting that payment be made to his or her personal service corporation, the amount should be considered wages. If, on the other hand, the personal service corporation contracts with the university/agency, and the corporation has a bona fide employer-employee relationship with the faculty/staff member, there may be enough substance to the relationship that it would be respected by the IRS. Remember, the IRS generally takes the position that if an employee performs any service for his/her employer, all payments to that employee should be treated as wages. In IRS Letter Ruling 9219020, the IRS determined that an employee who performed 95% of his/her services for the corporation to the employer, and only 5% to other entities was truly acting as an employee rather than an independent contractor through the corporation. Thus if the principal client of the personal service corporation is the university/agency, then the contracted service should be considered wages to the employee. A common area where this situation occurs is with those faculty members who teach continuing education courses.
1.4 IRS Reclassification of Independent Contractors to Employee Status
If the IRS reclassifies a significant number of independent contractors to employee status, the result is a substantial financial impact on the university/agency and the departments that are making these payments. In situations where intentional violations of employment tax rules and regulations are detected (i.e., changing a long-standing employee to an independent contractor in order to “save” payroll taxes and benefit costs), the IRS will assess taxes as follows:
- federal income tax at the applicable rate; and
- federal social security and Medicare tax assessment of 15.3%.
In some cases, the IRS can levy penalties and interest charges. Even if the taxes have already been paid by the individuals in question, the IRS will still make the tax assessment against the university/agency. It then becomes the responsibility of the university/agency to obtain repayment from the individuals in question (assuming the university/agency paid the tax assessment).
Additionally, reclassification to employee status may require that the employee be included in pension plans and other fringe benefit programs. The pension plan could be subject to penalty violations or even disqualification.
1.5 IRS Source Material Available
The IRS has an employee vs. independent contractor training manual available at their Internet address. This material can be used for training purposes but should not be cited as authority for setting or sustaining a technical position.