February 2008

About This Newsletter

Payroll Insights is a publication from KPMG LLP’s Employment Tax Practice. It is designed to provide you with current developments in the payroll and employment tax arena and will be published periodically throughout the year as developments warrant.

In This Issue

• Worker Classification Developments
• State Wrap Up

Worker Classification Developments

IRS Issues Fact Sheet on Employment Taxes and Classifying Workers

The Internal Revenue Service (IRS) has issued a fact sheet, FS-2007-27, to help business owners better understand their responsibilities regarding employment taxes and classifying workers. The fact sheet identifies the three key factors – behavioral control, financial control, and relationship of the parties – the IRS uses to determine if an employer-employee relationship exists and discusses employers’ employment tax obligations.

The first key factor the IRS looks to when determining if a worker should be classified as an employee or independent contractor is behavioral control. Specifically, does the company have the right to direct and control how the worker performs the task for which the worker is hired? Generally, the right to control what will be done and how it will be done is indicative of an employer-employee relationship – this is so even if a company gives the worker freedom of action. Behavioral control is evidenced if a company has the right to control details of how services are performed, such as when and where the work is performed, what tools or equipment are used, which workers are hired or who will assist with the work, where supplies and services are purchased, what work must be performed by a specified individual, and what order or sequence is to be followed.

The second key factor the IRS looks to when determining if a worker should be classified as an employee or independent contractor is financial control. Specifically, does the company have the right to direct and control the economic aspects of the worker’s activities? Generally, the IRS will look to factors such as whether the worker has a substantial investment in the work, can realize a profit or loss on a job, makes his or her services available to the public, has unreimbursed business expenses, can make business decisions that affect the worker’s bottom line, as well as how the worker is paid to determine if a company maintains financial control over the worker.

The third key factor the IRS looks to when determining if a worker should be classified as an employee or independent contractor is the relationship of the parties. When reviewing the relationship of the parties, the IRS will look at factors such as the term of the relationship, whether the worker gets any type of benefits (vacation and sick pay, pension plan, health insurance, life insurance, etc.), whether there is a written agreement in place between the parties, the permanency of the relationship (whether the relationship continues indefinitely or is only for a specific project or period), and whether the worker has his or her own business that is marketed to others to determine how the company and the worker perceive their relationship.

The IRS explains in the fact sheet that it is a common misconception that someone working part time or earning less than $600 per year should be classified as an independent contractor, when in fact, part-time status and the number of hours worked are generally not factors that determine whether a worker is an employee or independent contractor.

The IRS further notes in the fact sheet that employers are responsible for reporting and remitting employment taxes on payments made to employees (including federal personal income tax withholding, social security and Medicare taxes, and federal unemployment taxes) and discusses how businesses will generally not have to withhold or pay any such federal taxes on payments to independent contractors. The IRS also notes that employers that outsource some or all of their payroll duties are still ultimately responsible for the payment of taxes if the third-party provider fails to make employment tax deposits on their behalf.

Illinois: Appellate Court Finds “Referred” Workers Are Employees

The Appellate Court of Illinois has affirmed a lower court decision regarding the proper classification of “referred” workers as employees or independent contractors. SMRJ Inc. v. Russell, No. 1-07-0112, slip op. (Ill. App. Ct. Dec. 26, 2007).

SMRJ Inc. (d/b/a Four Boys Labor Service) refers individuals who perform services for client companies. Individuals would go to SMRJ to seek employment in the workforce and would complete and sign an Application for Eligibility Verification. The application would provide SMRJ with a basic profile and confirm that the worker (1) agreed to be treated as an independent contractor, (2) was not subject to withholding, (3) would be responsible for federal and state taxes, and (4) agreed to the payment of a service fee to SMRJ to be taken from the worker’s pay. Workers were paid by SMRJ, not the client companies.

An audit by the Director of the Illinois Department of Employment Security (Director) determined that workers referred to client companies should have been classified as employees of SMRJ and not independent contractors, resulting in an assessment against SMRJ of $95,159.16, including statutory interest of $36,894.75.

The Director based its findings on section 212 of the Illinois Administrative Code, which provides that three conditions must be satisfied for the independent contractor exception to the definition of employment to apply:

1. The individual has been and will continue to be free from control or direction over the performance of services, both under his contract of service and in fact; and
2. The service is either outside the usual course of the business for which the service is performed or the service is performed outside of all the places of business of the enterprise for which such service is performed; and
3. The individual is engaged in an independently established trade, occupation, profession, or business.

The Director’s audit focused on the third condition. The Director noted that the workers: did not appear to have an interest in an independent business, an investment in capital, or a gain or loss from a business; could not negotiate the fee charged by the company (their employment was dependent on SMRJ); could not seek employment directly from SMRJ’s clients; did not make their services available to the general public; did not have offices of their own; and did not maintain business listings.

The Director found that SMRJ failed to meet all three conditions set forth in the administrative code. However, failing to meet just one condition defeats an employer’s claim for an independent contractor exemption. Thus, SMRJ did not qualify for the exemption. The court agreed and affirmed the earlier decision.

Michigan Issues Misclassification Fact Sheet

Michigan’s Unemployment Insurance Agency has issued a fact sheet on misclassification of wages, describing the issue of misclassification, its consequences, and the state’s participation in the federal Questionable Employment Tax Practices (QETP) program. (Fact Sheet #116)

The fact sheet explains that the concept of “right of control” determines how a worker is classified and that independent contractors are in business for themselves and normally are hired to perform a specialized service that is not central to the overall function of the business for which they work. In addition, the fact sheet sets out the rules under the Economic Reality Test for Determining Contractor v. Employee Status.

The consequences of misclassifying workers affect the workers and the employer, as well as the government and taxpayers. Misclassified workers may be ineligible for unemployment insurance and workers’ compensation, lose labor law protections, become liable for their full social security taxes, or have to report their own income taxes. If a worker is paid in cash, FICA and social security taxes are not paid, thus affecting the amount of social security benefits the worker may receive at retirement. A misclassified worker may also lose access to employer-based benefits, such as health insurance.

Employers that misclassify workers’ wages avoid paying income, FICA, and unemployment taxes as well as workers’ compensation premiums on behalf of the workers. According to the fact sheet, such employers also create an unfair competitive advantage and underbid employers who do not misclassify their employees. Such employers may also be subject to penalties, including payment of required unemployment taxes, becoming the liable employer under Michigan law and undergoing scheduled audits to ensure compliance.

Misclassification affects government and taxpayers because underreporting results in a reduction in the amount of unemployment taxes being collected and made available for benefit payments, higher unemployment insurance taxes for other employers in the state, and uncollected FICA and income taxes.

Through the use of Form 1099-MISC from the IRS, and the state’s participation in the QETP, the agency’s field auditors are using IRS information to find misclassified wages and recoup unpaid unemployment insurance taxes. See the December 2007 issue of Payroll Insights for more on the QETP program.

New Definition of Independent Contractor Takes Effect in
New Hampshire

New Hampshire recently enacted legislation (SB 92, Chapter 362), effective January 1, 2008, that creates a uniform definition of employee and clarifies the criteria for exempting a worker from employee status. The legislature (the general court) recognized the need to protect workers from being improperly classified as independent contractors and denied workers’ compensation coverage and other benefits extended to employees. Therefore, the general court redefined “employee” under New Hampshire labor law in a manner that clarifies the criteria for the classification of a worker as an independent contractor.

The legislation standardized the definition of employee under New Hampshire’s Procuring Employment, Payment of Wages, Whistleblowers’ Protection, Minimum Wage, and Workers’ Compensation statutes such that an employee means and includes every person who may be permitted, required, or directed by an employer, in consideration of direct or indirect gain or profit, to engage in any employment. An individual will be considered an employee and not an independent contractor unless all of the following criteria are met:

• The individual has or has applied for a federal employer identification number, or social security number, or has agreed in writing to carry out the responsibilities imposed on employers;
• The individual has control and discretion over the means and manner of performance of the work, in that the result of the work, rather than the means or manner by which the work is performed, is the primary element bargained for by the employer;
• The individual has control over the time when the work is performed, and the time of performance is not dictated by the employer. However, the employer may reach an agreement with the individual as to a completion schedule, range of work hours, and maximum number of work hours to be provided by the individual, and in the case of entertainment, the time such entertainment is to be presented;
• The individual hires and pays the individual’s assistants, if any, and to the extent such assistants are employees, supervises the details of the assistants’ work;
• The individual holds himself or herself out to be in business for himself or herself;
• The individual has continuing or recurring business liabilities or obligations;
• The success or failure of the individual’s business depends on the relationship of business receipts to expenditures;
• The individual receives compensation for work or services performed and remuneration is not determined unilaterally by the hiring party;
• The individual is responsible for the main expenses related to the service or work performed, but the employer or individual offering work may provide the supplies or materials necessary to perform the work;
• The individual is responsible for satisfactory completion of work and may be held contractually responsible for failure to complete the work;
• The individual supplies the principal tools and instrumentalities used in the work, except that the employer may furnish tools or instrumentalities that are unique to the employer’s special requirements or are located on the employer’s premises; and
• The individual is not required to work exclusively for the employer.

State Wrap Up

Hawaii: 2008 Taxable Wage Base Reduced

Hawaii, which historically has had the highest wage base in the nation, has temporarily reduced its taxable wage base for calendar years 2008 through 2012. The taxable wage base for each of the five years will be $13,000. The 2008 taxable wage base was originally scheduled to be $36,500. The wage base will remain in effect throughout the period so long as the unemployment insurance trust fund does not fall below adequate reserves. (Hawaii Revised Statutes section 383-61.)

New Jersey: Electronic Reporting Requirements for Form WR-30

New Jersey changed its regulations regarding wage reports effective January 1, 2008. Because the Department of Labor and Workforce Development (the Department) no longer accepts reports on magnetic media, the term “magnetic media” has been replaced by “electronic transmission,” to reflect the use of e-mail and the Internet for filing reports. Similarly, amendments to wage reports must now also be filed electronically.

Previously, the submission of wage reports and contribution reports and contribution liability were linked. The Department no longer sees the need for this linkage; thus, the regulations no longer link these items.

Beginning in January 2008, all employers reporting in excess of 4 employees must now file Form WR-30, Employer Report of Wages Paid electronically. The prior threshold was 10 employees. The revised regulations also deleted obsolete provisions relating to reports filed between 1994 and 2000.

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