Proving credit worthiness
Health-care law raises concerns about defining independent contractors
- April 29, 2011
A new health-care tax credit for small businesses has renewed a decades-old debate over the definition of company employees versus independent contractors.
The tax credit, part of the 2010 Patient Protection and Affordable Care Act, is designed to give small businesses with fewer than 25 full-time employees breaks on health-care costs by providing a maximum credit up to 35 percent of premiums paid in 2010. That number increases to 50 percent in 2014.
For example, a mechanic with 10 employees who pays $70,000 in health-care costs would get a $24,500 tax credit in 2010 and a $30,000 credit in 2014.
Complicating the issue is the fact that the tax credit is available to companies that also use part-time workers beyond the 25-employee threshold. IRS now is giving more scrutiny to who is an independent contractor and who is an employee as companies apply for the tax credit. The potential exists for some companies to deliberately or accidentally list an independent contractor as a part-time employee (if they are at the threshold of 25 full-time employees with no other part-time employees) to get a bigger credit, then reclassify that worker as an independent contractor to avoid paying taxes. “Folks can always game the system and report inaccurate numbers,” says Ryan Losi, a CPA who is executive vice president and director of business development for Piascik and Associates in Richmond. “I believe it’s unlikely we’ll see widespread abuse.”
Since the depths of the 2007-09 recession, many companies have hired independent contractors rather than full-time employees as a way to control costs until they gain more confidence in the slowly recovering economy. As a result, the number of independent contractors has grown to 24 percent of the total work force, according to a Government Accountability Office estimate.
If an employer has to reclassify an independent contractor as an employee as a result of an IRS audit, the company may incur liability for withholding taxes for a number of years, have to pay interest and penalties and could face potential disqualification of employee benefit plans.
“What Congress has decided to do is use the tax code as the tool to administer benefits in the form of either the exclusion of income or deductions or credits or grants,” says Losi. “By doing that, they added to the complexity of the tax code. To get this health-care credit, you really have to understand the rules.”
In 1987, based on an examination of cases and rulings, the IRS developed a list of 20 factors in determining an employer-independent contractor relationship. A key consideration is the amount of control an employer has over an independent contractor on a project-by-project basis. The list was the result of a 1984 study by the IRS that found that employers misclassified 3.4 million workers as independent contractors, causing an estimated $1.6 billion loss in Social Security, unemployment and income taxes.
“It is really a facts-and-circumstances type test,” says Toby Ellison, CPA and senior manager of Cherry, Bekaert and Holland in Richmond. “Does the contract with that independent contractor feel more like an employment agreement or is it more of a truly independent relationship?”
But there are no hard-and-fast rules about the amount of control an employer can have to classify a worker as an independent contractor.
Interpretation of IRS compliance relies heavily on industry norms — the so-called common-law test that has proved to be increasingly problematic as emerging industries evolve.
The gray areas are numerous. Companies with government agency clients often must have their contractors submit to background checks, a move that suggests an employee relationship is developing. For example, Sheila Brooks, the president and CEO of Washington-based SRB Communications, has to have background checks conducted on her freelance business-development consulting and marketing people because of her contracts with government agencies such as the Department of Justice. “With our freelancers, we make it very clear that this is project specific,” she says. “They should not be there full time every day working on a number of projects because that is what an employee should do.”
Ellison says that small businesses need to pay close attention to this employee-independent contractor issue. “The take away is that companies need to be aware that there are some tough consequences — including missing out on this tax benefit if they are just calling someone an independent contractor who, if you peel everything back, looks and smells like an employee.”