Disputes concerning employee versus independent contractor have been going on for years. The last attempt by Congress at a fix was in 1978 (yes, that long ago!), and it only produced some penalty relief. Whether a worker is an employee or independent contractor can depend on IRS pronouncements, case law, etc., but it’s highly dependent on the facts and circumstances, as one U.S. Tax Court case illustrates.
Darryl Jones was an attorney and married to Tarri Harrold-Jones. They filed separate tax returns. Harrold-Jones owned and operated Tarri’s Business Services and performed services for Jones during 2007 and 2008. She reported the income from her husband’s office on a Schedule C as an independent contractor. The IRS sought to reclassify her as an employee of Jones.
Jones regularly hired extra workers to help him manage his caseload, and enlisted Harrold-Jones to work on two of his largest cases. The taxpayers were concerned that working together might damage their marriage, so they carefully arranged their business relationship to give Harrold-Jones as much freedom as possible. She did not work at the law office, but worked at the taxpayers’ home, which was 45 miles away. The attorney told her what he needed done, but allowed her to accomplish the tasks in her own time and in her own way. They agreed that he could discharge her if the arrangement became unproductive.
One of the cases Harrold-Jones worked on involved a protracted criminal investigation. According to court documents, the client had an “eccentric personality,” but got along well with Harrold-Jones. Therefore, Jones appointed her to work with the client, including reviewing documents. She also performed legal research in the law office. She received no regular wages. Her cases settled in 2007 and 2008 and she received a percentage of the fees collected.
Determining worker classification is a factual question in which common law principles apply. The IRS and courts generally look at the following seven factors in evaluating the relationship between the principal and the worker, and weigh those factors in determining the correct status.
1. Degree of control. The principal’s control over the details of the agent’s work is the most important factor in determining whether an employment relationship exists. In an employer-employee relationship, the principal must have the right to control not only the result of the employee’s work, but also the means and method used to accomplish the result. The degree of control can vary according to the nature of the services provided. If the work is more independent, a lesser degree of control can still result in a finding of an employer-employee relationship.
Jones did not control the details of his wife’s work. Her most important responsibility was keeping an important client calm and focused in the face of a lengthy criminal investigation. Jones cared only about the client’s satisfaction and did not control how Harrold-Jones achieved it. These facts suggested she was an independent contractor.
2. Investment in facilities. The fact that a worker provides his or her own facilities and equipment generally indicates independent contractor status. Harrold-Jones worked from her home office and the law office did not pay any of her expenses. This suggested she was an independent contractor.
3. Opportunity for profit or loss. When workers have no opportunities for profit or loss, they are more likely employees than independent contractors. Harrold-Jones received no regular wages and was compensated only after the cases she worked on settled. The payments depended on the amounts of the settlements and she conceivably could have received nothing for her efforts. She risked loss and her profits were linked to her performance. These facts suggested she was an independent contractor.
4. Right to discharge. The taxpayers admit Jones had the right to discharge his wife. This suggested she was an employee.
5. Part of the regular business. When a worker performs tasks in the ordinary course of a principal’s business, the worker appears to be more like an employee than an independent contractor. Harrold-Jones primarily worked on two cases. She reviewed documents with clients and performed general legal research. These activities were part of the regular business of the law office. These facts suggested she was an employee.
6. Permanency of the relationship. A transitory work relationship may indicate independent contractor status. Harrold-Jones worked for the law office only while the two cases assigned to her were ongoing. At the time of the trial, she had not worked for the office since the cases settled. Although she worked for the law office for five or six years, her tenure was dependent on the continuation of her cases and could have ended at any time. Her tenure was lengthy, but not permanent. These facts suggested she was an independent contractor.
7. The relationship the parties think they are creating. The law office treated Harrold-Jones as an independent contractor and she considered herself an independent contractor. The office issued Forms 1099-MISC and she paid the self-employment tax. The record reflected that neither party thought she was an employee. This indicated she was an independent contractor.
After weighing all the factors, the Court concluded the wife was an independent contractor during the years at issue. Although some of the factors suggested she was an employee, on balance, the record indicated she was an independent contractor. (Darryl L. Jones, T.C. Memo. 2014-125)
While the court found five of the seven factors on the taxpayers’ side, it’s often a closer call. And the IRS and the courts can, and frequently do, assign different weight to the factors.
The facts are critical. In this case, they lined up in favor of the taxpayer. There may be ways you can nudge some of them in your favor. This might include letting the individual work from home or outside the office, set his or her own hours, and pay expenses rather than reimbursing him or her and avoiding control. Each situation is likely to be unique. It’s generally a good idea to consult with your tax advisor (which may also help you to avoid penalties).
While it wasn’t mentioned in any detail in the Jones case, it sounded like the wife was familiar enough with the work that she needed no direction. That’s often an important factor. Being able to show that a worker has done a similar job at other firms is a help. It’s even better if the worker has some professional credentials.
It appears the wife also had her own business (although we don’t know the details). If the worker does a similar job for other firms at the same time — or from time to time — that indicates an independent contractor.
Consistency is important. Treating some workers doing similar tasks and in similar situations differently is likely to raise questions. Reliance on how other firms in the same industry treat workers can also be a factor. You’re on safer ground if there is some industry consensus.
If the payment is large enough to require a Form 1099-MISC, make sure your law firm files one.
A relationship based on one, or only a few clearly defined assignments, will bolster your case for the worker being an independent contractor. A contract defining the scope of the work, what’s expected and the reasons for discharge (for example, failure to meet milestones) is a big plus. Some cases have turned on this.
If you’re audited, expect a challenge. It’s an IRS hot button. In addition to having facts on your side, you should have any required documentation — including 1099 forms, an opinion from your tax advisor, contracts, as well as any documents related to the work assigned and performed, such as dates of service.
If the issues weren’t complicated enough, some states have stricter rules. Keep in mind that if a worker is reclassified from an independent contractor to an employee, it can be very expensive. In addition to federal taxes and penalties, there can be state taxes and penalties, unemployment insurance, Workers’ Compensation, as well as other potential issues.
Please contact Judy Barnhard via our online contact form with any questions.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.