Tuesday, October 12, 2010
Payroll Tip - Determining A Worker's Status
There are many types of workers that provide services for employers— leased employees, temporary help agency referrals, independent contractors, common-law employees, statutory employees, and statutory nonemployees. This article describes each and relates the guidelines for determining the status of a worker.
An employee, unlike other workers, is paid through the payroll department. This is because the employee is subject to many legal and tax requirements that cannot be effectively administered in the accounts payable area. The payroll function is specialized to handle the unique tax and reporting requirements associated with wage payments.
Leased Employees and Temporary Help Agencies
Employee leasing agencies, also known as professional employer organizations (PEOs), hire employees for the client firm and assume the administrative tasks of payroll and human resources. The client firm has final say over the hiring and firing of the leased employees, sets wage levels, and oversees the work. Leased employees are nevertheless employees of the leasing agency, not of the client firm. The client firm pays the leasing agency through its general fund rather than through the payroll account.
EXAMPLE: Slo Poke Manufacturing leases all 35 of its employees from Workforce Leasing, an employee leasing agency. Slo Poke interviews each candidate referred by Workforce Leasing and makes the final decision to hire. Slo Poke also conducts regular performance appraisals of the leased employees and requests that Workforce Leasing terminate poor performers. Slo Poke Manufacturing pays Workforce Leasing $95,000 per month for the services of the leased employees.
UNEMPLOYMENT EXCEPTION Some states do not recognize the PEO as the employer for state unemployment insurance purposes. In such case, the employer must file unemployment returns and pay unemployment insurance under its own EIN. Check the state requirements.
The benefits of leased employees:
•Lower-priced benefits packages. Employers with fewer than 100 employees may have difficulty obtaining favorable group rates for benefits such as health and life insurance. The leasing company, on the other hand, qualifies for reduced group rates because it acts as the employer for several client firms. In addition, the small employer generally cannot afford to invest in full-time employees who are dedicated to the task of administering the payroll and human resources functions. For these reasons, employee leasing agencies are particularly appealing to the small business.
•Resource for specialized skills. Leasing companies are sometimes used to fill the need for a specialized group of workers for a particular job, location, or facility.
•Cut administrative overhead. Increasingly, large employers are turning to employee leasing agencies for relief from the administrative burden of complying with payroll and employment practice requirements.
Pitfalls to avoid with leased employees and other third-party contractor services:
•Leased employees must be on someone's payroll. In the past, agencies would refer “independent contractors” to the client firm. The Tax Reform Act of 1986 clarified that leased employees who provide services to a client as an engineer, designer, drafter, computer programmer, systems analyst, and other similarly skilled worker engaged in a similar line of work must be treated as employees of the leasing company.
•Pension and retirement plans. The various IRS regulations that have been adopted to prevent avoidance of employee benefits requirements may require consideration. For instance, the employer may be required to include leased employees in its pension and retirement plans. The additional cost of providing benefits to leased employees should be considered when the contract is negotiated with the leasing agency.
•State unemployment. In some states, the leasing company is not recognized as the employer and the client firm may be required to pay state unemployment tax on its leased employees' wages. In these cases, the leasing company will often file the client firm's unemployment tax returns as an agent of the client.
•Liability for taxation and reporting. The IRS can hold the client company liable for tax reporting or deposit failures. For this reason it is important to ensure that the leasing company has a history of meeting tax and reporting requirements and that there are periodic checks in place to confirm that the leasing company is filing returns and depositing taxes correctly and on time. (Additionally, funds provided to the third party to meet other payroll obligations may be impounded for debts of the PEO if not insured through a trust instrument.)
•Compliance with wage-hour law. Both the client firm and the PEO are jointly responsible for complying with federal and state wage-hour law, including garnishments. In fact, the greatest weight of responsibility lies with the client, because the client firm has direct control of the work schedule, time reporting, etc.
Temporary help agencies: Unlike employee leasing agencies, temporary help agencies do not hire employees for lease to a specific client firm. Instead, employees are hired by the temporary agency to provide short-term services for many client companies. The client firm does not have the final say over the hiring and firing of the temporary agency's employees, although the services of a specific temporary employee may be requested. The temporary agency referral is an employee of the temporary agency and not the client firm. The temporary help agency assumes the payroll and human resources responsibilities.
EXAMPLE: AB Pharmaceutical needs assistance preparing Forms W-2 for distribution. The payroll manager calls Rent-a-Temp for one week of temporary assistance. Rent-a-Temp sends its employee Joan Smith. AB Pharmaceutical will pay $500 to Rent-a-Temp for one week of Joan's services. Joan will be assigned to a new client firm when her assignment with AB Pharmaceutical is completed.
The benefits of temporary help agency referrals:
•Eliminate risk of unemployment claims. Many employers find temporary help agencies cost-effective when employees are needed for short-term projects. By using a temporary help agency, the employer can terminate the employment relationship at the end of the project without a potential liability for benefit charges to its unemployment account.
BUYER BEWARE If the employee leasing agency or temporary help agency should fail to pay its federal payroll taxes or if a settlement liability is incurred as a result of a federal/state labor law violation, the client business, not the temporary help or leasing agency, may be forced to pay the underwithheld tax, employer taxes, penalty, and interest. This would be true, for example, if an employee leasing agency or temporary help agency were to file for bankruptcy. It is important that employers do business with agencies that have well established reputations and are financially stable. An individual or a department within the organization, such as human resources, should conduct a careful review of leasing or temporary help agencies before engaging their services. In addition, all supervisors and department heads should clear requests for temporary help or leased employees through the individual or department within the organization responsible for agency review and selection.
Employees may be entitled to participate in the benefit plans of both the client firm and the temp agency: A 1999 refusal by the Supreme Court to hear Microsoft's appeal of a federal court ruling has increased the possibility that client firms may be required to permit employees of temporary help agencies to participate in their fringe benefit plans.
•The facts of the case. The U.S. Court of Appeals for the Ninth Circuit ruled in May 1999 that all Microsoft workers since December 29, 1986 who worked at least 20 hours per week for five months of the year and met the common-law definition of an employee should be allowed to continue their claims against the company for benefits under certain of Microsoft's fringe benefit plans. In its appeal, Microsoft argued that the U.S. Court of Appeals decision covered too broad a class of former workers and by doing so gave individuals employed by temporary employment agencies access to double the benefits—benefits through the temp agency and also through its plans.
The refusal of the Supreme Court to review Microsoft's appeal has temporary employment agencies concerned that client firms will be reluctant to use their services because of the risk of incurring additional fringe benefit costs. In a “friend of the court” brief supporting Microsoft's appeal, the Information Technology Association of America, the American Staffing Association, the Association of Private Pension and Welfare Plans, and the U.S. Chamber of Commerce, among others, argued that the appeals court decision that temporary service employees may be considered employed by both the agency and the company contracting with the agency violates the Employee Retirement Income Security Act. According to the brief, the decision “exposes the thousands of businesses that use staffing firm employees for legitimate business reasons to lawsuits for retroactive employee benefit coverage by plaintiffs looking for a windfall.”
The case was returned to the U.S. District Court in Seattle for a determination of the number of temporary workers that will benefit from the court decision and the amount of compensation owed them.
IRS provides guidance on the exclusion of reclassified workers from employer benefit plans: The IRS unofficially released a technical advice memorandum (TAM) in response to a request from the IRS Cincinnati key District Office, in which it concludes that individuals, including those later reclassified as common-law employees, can be excluded from participation in an employer's pension plan. A TAM is advice or guidance in the form of a memorandum furnished by the IRS National Office upon the request of a district director or appeals office chief in response to any technical or procedural question that develops during any proceeding. While a TAM is requested by the District Office or Appeals, a taxpayer may request that the District Office obtain a TAM. A TAM is generally binding on the District Office or Appeals but is not binding on the taxpayer; however, TAMs are useful in understanding IRS thinking on the issues raised.
•The facts. The taxpayer had two pension plans, amended in 1998, that included a clause stating that to be eligible under the plans, an individual must be “reported on the payroll records” as a common-law employee. Further, the plans specifically excluded "any other common law employee or any leased employee,” and stated that "individuals not treated as common law employees are to be excluded even if a court or administrative agency determines that such individuals are common law employees and not independent contractors.”One of the plans also excluded individuals classified as “special assignment” workers from pension plan participation. The special assignment classification included two types of workers: (1) those hired to perform work on specific contracts with specific deadlines for specific compensation and benefits, and (2) salaried union employees who had been laid off and were on an "inactive seniority” list. The second category would be rehired for project work for a set period of time and were not entitled to participate in the retirement plan.
•IRS conclusion. In its memorandum, the IRS concluded that [IRC §410(a)] does not prohibit employers from excluding from retirement plan participation whichever classifications of employees it chooses to exclude, unless, with limited exceptions, the exclusions are based on age or service. Similarly, IRS regulations do not preclude an employer from placing conditions on participation, unless, as stated previously, these conditions are based on age or service. In fact, IRS regulations permit an employer to condition participation on "those employees being employed within a specific job classification.”
The IRS commented that many employers have amended their retirement plans in the wake of the decision in Vizcaino v. Microsoft in an attempt to protect their plans against the uncertainty that may be created by retroactive IRS determinations that workers are common law employees rather than independent contractors. In the Microsoft case, workers who were initially classified as independent contractors were later determined by the IRS to be common-law employees for employment tax purposes. As a result, the workers claimed benefits under Microsoft's benefit plans, including Microsoft's §401(k) plan. Microsoft's §401(k) plan limited participation to employees on its U.S. payroll.
The Ninth Circuit concluded that because the workers were reclassified as common-law employees they were eligible, under the plan's terms, to participate in the §401(k) plan. Subsequent appeals by Microsoft have been unsuccessful in overturning this decision.
In conclusion, the IRS ruled that the taxpayer's two retirement plans could be designed to exclude from participation employees who were either not reported on the company's payroll records as common-law employees, even if a court or administrative agency later determines such individuals to be common-law employees, and those individuals identified by a specified job classification code in the employer's payroll records. The IRS also held that the taxpayer's retirement plans met the definite written plan requirement under the Internal Revenue Code because the identification of who is included or excluded under the plan could be clearly understood by the company's employees, the plan administrator, and the plan fiduciaries.
Unlike employees, independent contractors carry on an independent trade or business, generally providing services for (and actively seeking work from) more than one employer. In most cases, the services provided by an independent contractor, unlike those provided by an employee, are not integral to the employer's primary business.
EXAMPLE: Sam's bakery engaged the services of an independent contractor to repair and maintain the heating and cooling system on a monthly basis. Sam's primary business is the preparation and distribution of baked goods. The heating and cooling system is merely incidental to the primary business of the bakery.
The independent contractor is in fact independent. Unlike the leased employee or temporary help agency referral, the independent contractor is an employee of no other entity. Rather, the independent contractor is “self-employed” or is an “employer.”
The designation of “independent contractor” is often applied loosely to workers who are in fact “employees.”Although there are no clear guidelines for distinguishing an employee from an independent contractor, definitions and general rules are offered by various federal and state agencies. It should be emphasized that governmental agencies always favor the employee designation; therefore, the employer must provide compelling proof that workers are properly designated as independent contractors.
Independent Contractor vs. Employee
What is the difference between an employee and an independent contractor? For government agencies, the big difference is revenue. Studies by the General Accounting Office (GAO) have shown that the U.S. Treasury Department loses billions of dollars in annual tax revenue due to worker misclassification. This loss of revenue is precisely why government agencies are cracking down on employers that misuse the independent contractor designation.
There are other important differences as well.
•An employee generally is covered by federal and state wage-hour laws (see Chapter 4 of Principles of Payroll Administration).
•The employer generally is required to pay the applicable employer portion of Social Security and Medicare (FICA) tax and withhold the employee portion of FICA tax from employees.
•The employer generally is required to withhold federal, state, and local income tax from the wages of employees.
•The employer generally is required to report wages and taxes withheld from employees on the Form W-2 and other wage and tax returns.
•The employer is required to pay any applicable federal and state unemployment/disability insurance taxes.
•The employer is required to deposit taxes with the IRS and other taxing authorities under the applicable depository regulations.
•Any “fees” or payments of $600 or more in a calendar year are reported by the payer on Form 1099-MISC. (Most states impose the same or a similar reporting requirement.)
•If the independent contractor has not provided a taxpayer identification number (TIN) to the payer, a 28% (for 2009 and 2010) backup tax must be withheld by the payer (on payments of $600 or more in the year) and submitted to the IRS under the depository regulations.
•The independent contractor is responsible for the payment and reporting of the applicable state and local taxes; federal income tax (FIT); and tax under the Self-Employment Contributions Act (SECA) which is currently equal to the employee and employer portion of Social Security and Medicare.
Common-Law Employee vs. Statutory Employee
Common-law employee: A common-law employee is one who meets the common-law test. The employer is required to withhold FIT and FICA tax from the “wages” paid to common-law employees. In addition, the employer is required to pay federal (and state) unemployment tax and its share of FICA tax on the taxable amount.
Statutory employee: Payments made to statutory employees are not subject to federal income tax withholding but are subject to FICA withholding. In addition, the employer is required to pay federal unemployment tax (FUTA) and its share of FICA on the taxable amount.
A “statutory employee” is any individual who falls into one of the following categories:
•A driver who is an agent of the employer or is paid on a commission basis, who distributes meat, vegetables, fruit, baked goods, or beverages (other than milk) or picks up and delivers laundry or dry cleaning.
•A full-time life insurance sales agent, whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company; however, if these individuals are paid strictly on a commission basis, their commissions may be exempt from FUTA.
•Certain homeworkers, who work at home on materials or goods the employer supplies. The work must be returned to the employer or to a person the employer names. The employer provides the specifications for the work that is to be done by the homeworker.
•A full-time traveling or city salesperson, who works on the employer's behalf and takes orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed by the salesperson must be his or her principal activity.
NOTE Statutory employees under [IRC §3121(d)(3)] are independent contractors for all purposes other than Social Security and Medicare taxes. This means that they report their income and expenses on Schedule C, and are not subject to the limitations that pertain to employer-reimbursed business expenses. If workers are common-law employees, they are not statutory employees merely because they provide the type of service described in [IRC §3121(d)(3)] or merely because the employer checked the “statutory employee” indicator in box 13 of the Form W-2. These common-law employees (i.e., workers who provide the type of service described in [IRC §3121(d)(3)] but otherwise meet the definition of a common-law employee) often request that employers check the “statutory employee” box because they would like to report their business expenses on Schedule C rather than itemize their deductions on Schedule A.
Statutory nonemployees: The employer is not required to withhold FIT or FICA taxes from payments made to statutory nonemployees, nor are the payments subject to FUTA tax.
There are two groups of employees meeting the definition of statutory nonemployee—direct sellers and licensed real estate agents. These workers are treated as self-employed for federal income and SECA tax purposes if:
1.substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other achievements, rather than to the number of hours worked; and
2.the services of the real estate agents are performed under a written contract that stipulates that they will not be treated as employees for employment tax purposes (e.g., FIT, FICA, and FUTA).
•Direct sellers.Direct sellers are people engaged in (1) selling consumer products in the home or at the place of business other than a permanent retail establishment, or (2) selling consumer products to any buyer on a buy-sell basis, or any similar basis prescribed by regulations, for resale in the home or at a place of business other than in a permanent retail establishment. (Most states do not exempt these individuals from state unemployment tax.)
Effective January 1, 1996, a person engaged in the trade or business of the delivery or distribution of newspapers or shopping news (including any services that are directly related to such trade or business such as solicitation of customers or collection of receipts) is a direct seller. Wages paid to him or her are exempt from employment tax provided that (1) substantially all the compensation for the performance of the services is directly related to sales or other output rather than to the number of hours worked, (2) the services performed by the person are performed pursuant to a written contract between such person and the service recipient, and (3) such contract provides that the person will not be treated as an employee for federal tax purposes.
•Licensed real estate agents. Licensed real estate agents include individuals engaged in appraisal activities for real estate sales if they earn compensation based on sales or other achievements.