Independent Contractor

Independent Contractor vs. Employee:

The tax law covering independent contractors is not simple. There are numerous factors which impact the way the IRS will view your case concerning independent contractor/employee relationship. As you may already know, employers are required to withhold income tax, withhold and send payment of both Social Security and Medicare tax, and pay unemployment taxes on employee wages. In the case of independent contractors, the employer generally does not withhold or pay taxes on compensation paid to independent contractors.

Determination of the status of a worker, independent contractor vs. employee, requires that any and all information that can help quantify the level of control and independence the worker has in performance of official duties must be considered. Word of Caution: if employees are classified incorrectly as independent contractors, the employer can be liable for employees’ employment taxes as well as penalties.

Misclassifying a worker as an independent contractor or employee can lead to significant tax liabilities, tax penalties, and audits from the Internal Revenue Service (IRS) and California’s Employment Development Department (EDD). The distinction between these classifications is complex, governed by intricate tax laws and nuanced factors that require careful tax legal analysis. At Tax Lawyers Group APC, our Los Angeles-based tax attorneys specialize in helping businesses and individuals correctly classify workers, resolve disputes, and achieve compliance with IRS and EDD regulations.

Why Worker Classification Matters

The classification of a worker as an independent contractor or employee has significant tax and legal implications for both the worker and the hiring entity. Key differences include:

• Employees: Employers must withhold federal and state income taxes, Social Security, and Medicare taxes from employee wages. They are also responsible for paying the employer’s share of Social Security and Medicare taxes, federal and state unemployment taxes (FUTA and SUI), and workers’ compensation insurance. Employees are typically entitled to benefits like overtime pay, minimum wage, and protections under labor laws.
• Independent Contractors: Employers are not required to withhold or pay taxes on payments to independent contractors. Contractors are responsible for their own income taxes, self-employment taxes (covering Social Security and Medicare), and estimated tax payments. They generally do not receive employee benefits or labor law protections.

Misclassifying an employee as an independent contractor can result in severe consequences, including:

• Tax Liabilities: The employer may be liable for unpaid employment taxes, including both the employee’s and employer’s share, dating back to the period of misclassification.
• Tax Penalties and Interest: The IRS and EDD may impose penalties for failure to withhold taxes, late payments, or inaccurate reporting, plus interest on unpaid amounts.
• Tax Audits and Investigations: Misclassification is a common trigger for IRS and EDD audits, which can be time-consuming and costly.
• Labor Law Violations: Misclassified employees may file claims for unpaid wages, overtime, or benefits, exposing the employer to additional legal risks.

IRS and EDD Criteria for Worker Classification

Determining whether a worker is an independent contractor or employee requires a detailed analysis of the relationship between the worker and the hiring entity. Both the IRS and EDD focus on the degree of control and independence in the working relationship, evaluating factors such as behavioral control, financial control, and the nature of the relationship. While the IRS and EDD share similar principles, their specific tests and interpretations may differ.

IRS Classification Framework

The IRS uses a Common Law Test, emphasizing three main categories to assess control and independence:

1. Behavioral Control:
   • Independent Contractor: The payer controls only the result of the work, not how it is performed. For example, the contractor decides their work hours, methods, and tools.
   • Employee: The employer controls what tasks are performed and how they are done, such as setting work schedules, providing training, or requiring specific procedures.
2. Financial Control:
   • Independent Contractor: The worker has significant financial independence, such as bearing their own business expenses (e.g., tools, travel), having the opportunity for profit or loss, or working for multiple clients.
   • Employee: The employer covers work-related expenses, pays a fixed salary or hourly wage, and limits the worker’s ability to seek other clients.
3. Type of Relationship:
   • Independent Contractor: The relationship is typically project-based or temporary, with no expectation of benefits (e.g., health insurance, paid leave) or long-term commitment.
   • Employee: The relationship is ongoing, often with benefits, written contracts, or integration into the employer’s core business operations.

The IRS also considers specific worker categories that may be statutorily classified as employees, even if they meet independent contractor criteria. These include life insurance sales agents, certain delivery drivers (e.g., for food or laundry), and home-based workers performing tasks under specific employer instructions.

EDD Classification Framework

In California, the EDD primarily uses the ABC Test under Assembly Bill 5 (AB5), effective January 1, 2020, for most industries, unless an exemption applies. The ABC Test presumes a worker is an employee unless the employer can prove all three of the following:

• A: The worker is free from the control and direction of the hiring entity in performing the work, both under the contract and in practice.
• B: The work performed is outside the usual course of the hiring entity’s business.
• C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

If the ABC Test does not apply (e.g., due to an industry exemption), the EDD may use the Borello Test, which is similar to the IRS Common Law Test, focusing on factors like control, integration into the business, and the worker’s opportunity for profit or loss.

The interplay between IRS and EDD standards creates a complex landscape, with significant “gray areas” open to interpretation. Missteps in classification can lead to disputes, making professional guidance essential.

Consequences of Misclassification

If the IRS or EDD determines that a worker was incorrectly classified as an independent contractor, the employer may face:

• Retroactive Tax Liabilities: Payment of unpaid employment taxes, including Social Security, Medicare, income tax withholdings, and unemployment taxes.
• Penalties: Fines for failure to withhold, failure to file accurate Forms W-2 or 941, or intentional disregard of tax rules.
• Interest: Accrued on unpaid taxes and penalties, compounding daily.
• Worker Claims: Misclassified workers may seek back wages, overtime, benefits, or other labor law protections.
• Reputational Damage: Public audits or lawsuits can harm a business’s reputation and financial stability.

These risks underscore the importance of proactive classification and tax compliance.

How Tax Lawyers Group APC Can Help

At Tax Lawyers Group APC, our Los Angeles tax attorneys provide comprehensive services to ensure accurate worker classifications and resolve IRS or EDD disputes. Our approach includes:

1. Detailed Classification Analysis:
   • We conduct an in-depth review of your worker relationships, examining contracts, job descriptions, payment structures, and work practices.
   • We apply IRS Common Law Test and EDD ABC or Borello Test criteria to determine the correct classification, identifying any gray areas or risks.
   • For specific industries (e.g., gig economy, delivery, or insurance), we account for statutory employee rules or AB5 exemptions.
2. Compliance Strategies:
   • We develop tailored policies and contracts to support independent contractor status, such as clear agreements outlining limited control and independent business operations.
   • We advise on restructuring worker relationships to align with IRS and EDD standards, minimizing the risk of misclassification.
3. Tax Audit and Dispute Defense:
   • If you’re facing an IRS or EDD audit, we represent you in negotiations, presenting evidence to support your classifications and challenging erroneous tax assessments.
   • We pursue tax penalty abatement or voluntary reclassification programs, such as the IRS Voluntary Classification Settlement Program (VCSP), to reduce liabilities.
4. Tax Debt Resolution:
   • If misclassification results in tax liabilities, we explore relief options, including Offers in Compromise, installment agreements, or tax penalty abatement, to manage or reduce the debt.
   • We address related issues, such as unfiled Forms 941 or 1099, to achieve full compliance.
5. Proactive Planning:
   • We provide ongoing guidance to maintain compliance, including training on worker classification best practices and updates on changing laws (e.g., AB5 amendments or federal gig economy regulations).

Why Choose Tax Lawyers Group APC?

At Tax Lawyers Group APC, our Los Angeles tax attorneys bring unparalleled expertise and a client-centered approach to worker classification issues. Here’s why we’re the trusted choice:

• Specialized Knowledge: Our team has extensive experience with IRS and EDD regulations, including the nuances of Common Law, ABC, and Borello tests.
• Proven Success: We’ve successfully guided hundreds of businesses through independent contractor reclassification disputes, tax audits, and penalty abatement, saving clients significant costs.
• Comprehensive Analysis: We leave no stone unturned, thoroughly evaluating all factors of control and independence to ensure accurate classifications.
• Strategic Advocacy: We negotiate with the IRS and EDD on your behalf, defending your worker classifications and securing favorable resolutions.
• Total Tax Solutions Beyond classification, we address related tax issues, such as liens, levies, or unfiled returns, to achieve long-term compliance and stability.

At Tax Lawyers Group APC, our Los Angeles tax attorneys are ready to analyze your worker relationships, resolve disputes, and implement strategies to safeguard your business.

Contact us today at (310) 788-9820 or email us to schedule a confidential consultation. We’ll review your worker classifications and develop a tailored plan to achieve compliance with the IRS and EDD.