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Employee or Independent Contractor? Two Tax Court Cases
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© 2011, Powered by Does your firm use outside workers for some jobs? This can result in significant tax breaks
BizActions if the workers are properly classified as independent contractors rather than employees.

Key point: If a worker is an employee, your company must withhold federal income tax
and employment taxes from his or her wages. In addition, your business is responsible for
paying the employer's share of federal payroll taxes. Conversely, if a worker is
characterized as an independent contractor, your company isn't liable for these payroll tax
obligations.

In addition, employers aren't required to offer independent contractors the same fringe
benefits that regular employees receive, which can result in extra savings.

However, it's not always easy to distinguish independent contractors from

employees. There are several factors the IRS and courts examine but it often boils down to
a "control" issue. If you control how, where and when the worker does the job, he or she is
usually classified as an employee.

Here are two cases heard in U.S. Tax Court that illustrate some of the traps that taxpayers
can fall into on the employee-versus-independent-contractor issue:

Case #1: Tax Court Disregards Contracts

An Ohio trucking firm had written contracts with drivers to operate as independent
contractors. The company filed 1099 Forms with the IRS for each of the drivers working
under the contract. Nevertheless, the corporation:

Hired drivers, oversaw all work performed by them and confirmed the work had
been completed.
Directed, supervised, paid,
disciplined and discharged the

drivers.
Decided which days that
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Decided which days that

drivers would work and which
loads they carried.
Determined when repairs to
the trucks were necessary and
was responsible for truck
maintenance. The drivers had
no investment in the trucks.

Based on these facts, the Tax Court
ruled that the drivers should be
treated as employees, despite the
existence of the written contracts,
because the company exerted
significant control over their activities.
(Peno Trucking, Inc., TC Memo
2007-66)
Footnote: The trucking firm argued
that it should be entitled to "Section
530 relief" based on its consistent
treatment of workers as independent
contractors and the fact that two prior
Workers' Compensation requests by
drivers were denied by the state due
to their written contracts. (See right-
hand box for an explanation of
Section 530 relief). But the Tax Court
stated the Workers' Comp cases did decision or IRS ruling to support its position.
not evaluate the employment
relationships "through a common law
analysis."
Under Section 530 of the Revenue Act of 1978,
an employer can claim independent contractor
status for misclassified workers and not owe
employment taxes if it can show:
There is a "reasonable basis" for the
classification.
The business consistently treated workers
as contractors.
Here are the ways to qualify for Section 530
relief:
1. The classification is a long-standing practice
of a significant segment of the industry or
profession.
2. The employer was audited regarding the
employment tax treatment of workers and the
classification was allowed to stand.
3. The employer relies on an authoritative court
4. The employer based the determination on
the sound reasoning of a paid tax professional.

Case #2: Are Workers Liable for Taxes if an Employer Wrongly Classifies Them?

What happens if an employer misclassifies a worker as an independent contractor and

doesn't withhold income taxes or FICA? Does that mean the person is not liable for the
taxes? One Florida woman found out the hard way that the answer is "no."

She worked as a seamstress at a retail bridal gown shop. The shop classified the woman
as an independent contractor and paid her $11,210 during the year in question. The shop
did not withhold income or employment taxes from its payments to her. The seamstress
also received unemployment compensation of $208 that year from the Florida Agency for
Workforce Innovation.

The woman also failed to file a tax return for the year. So the IRS filed one for her as a
self-employed person with its "Substitute for Return Program" and sent her a tax bill. Later,
the IRS agreed that the seamstress was an employee, rather than an independent
contractor. The woman contended that the bridal shop, which failed to withhold taxes from
her wages, was solely liable for the tax bill.

The Tax Court stated that it was "unfortunate" the employer classified the seamstress as
an independent contractor and not as an employee.

But, the court added, "that does not alter the fact that the first principle of income taxation
is that income must be taxed to (the person) who earns it" and "misclassification of an
employee does not relieve the employee of his liability for filing a correct tax return."
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employee does not relieve the employee of his liability for filing a correct tax return."
(Natalia Ravelo Escandon, TC Memo 2007-128)

These two cases are two in a long list of court filings against companies that hire
independent contractors. In some cases, workers sue for benefits they claim they were
eligible for, including health insurance and retirement plan contributions.

To make matters worse, the IRS continues cracking down on companies that hire
independent contractors. If the tax agency "reclassifies" a worker as an employee, your
company could be slapped with hefty bills for back taxes, interest and penalties. Audits by
state agencies are also common and frequently occur when independent contractors apply
for unemployment or Workers' Compensation.

Unfortunately, no single factor determines a worker's status. In the trucking company case
described above, the Tax Court looked at these seven questions:

1. What degree of control is exercised by the business? Under this test,

the court examined how much control the company exerted over the way the
services were performed. But exercising control is not required in an
employer-employee relationship, the Tax Court noted, as long as
the company has the right to direct a worker if necessary.

2. Which party invests in "work facilities," used by the individual? "The

fact that a worker provides his or her own tools generally indicates a non-
employee status," the Tax Court explained.

3. Does the individual take any financial risk? "A worker's opportunity to
earn a profit and assume risk of loss may indicate a non-employee status,"
the Court stated.

4. Can the business discharge the individual? "Generally, an employer's

right to discharge an employee indicates an employer-employee relationship,"
the Tax Court noted.

5. Is the work an integral part of the company's regular business? An

employer-employee relationship is supported when workers perform a service
essential to the success of a business operation.

6. How permanent is the relationship? The Tax Court stated that "a
transitory work relationship may point toward a non-employee status."

7. What kind of relationship do the parties believe they are creating?

Entering into a written agreement that states a worker is an independent
contractor indicates a non-employee relationship. However, a contract alone
is not enough. "If an employer-employee relationship exists, characterization
by the parties as some other relationship is immaterial," according to the Tax
Court.

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