Avoiding the Trust Fund Liability Penalty
A Case Study on The Employee-Independent Contractor Conundrum
The following case study highlights the consequences of making a decision based solely upon financial considerations, without first consulting a tax attorney. Intellectual arrogance can have devastating financial consequences, and in some cases, result in imprisonment.
Eric Wilson started a landscape design and maintenance business, which he operates out of the basement of his home. Eric wants to limit his overhead, and accordingly, decides to treat all new hires as independent contractors. He arrives at this decision after reading an article on the internet entitled: “How to minimize or eliminate employment withholding tax and health insurance coverage?”
As part of the organization process and with the assistance of Legal Zoom.com, Eric forms a single member limited liability company and names the entity Princeton Landscape Design Services, LLC (“Princeton”). Eric also applies for and receives a federal tax identification number. In this regard, Eric prepares Form SS-4 (Application Federal Employee Identification Number). In response to question 13 of Form SS-4, Eric indicates that the number of employees is zero. Eric signs Form SS-4 under penalty of perjury.
Eric also goes online and purchases a template for an Employee Handbook and fills in the blanks, outlining the minimum and maximum number of hours an individual can work during any given week as well as the allowance for sick or personal days, vacation time and holidays, overtime policy and hours of operation. In addition, the Handbook provides the causes for termination.
The Handbook provides that each new hire is to receive his or her assignments directly from Eric and also required to report to work wearing a hat and tee shirt bearing the Princeton name and logo. The new hires are required to report to Eric’s house at the beginning of the workday. Eric then dispatches his workers to the job site. For purpose of branding the Princeton name, individuals must travel to the job site in one of the three company trucks, all of which prominently display the Princeton name and logo as well as the company’s contact information. Each truck is also fully equipped tools and necessary supplies required for the job site.
In the event of a customer complaint, the Handbook provides that the Princeton Worker is to call the Princeton’s office and report the matter to Eric, who has exclusive authority to resolve any customer complaint or problem on the job.
Eric hires twenty individuals including a landscape architect, landscapers, helpers, masons, plumbers, irrigation specialists and an office manager.
Eric supervises his workers to assure that the designs that he approves are being adhered to by Princeton’s workers. He also spends time on the job site to meet with inspectors and to inspect the delivery of materials. On average, Eric spends 2 hours each day on the job site.
All new hires are provided with a copy of the Handbook and required to sign a document acknowledging that the new hire has read the Handbook, understood it and agrees to abide by all of its terms.
Princeton also requires that a new hire sign a statement entitled “Independent Contractor Statement.” The Statement, which was prepared by Eric without the assistance of an attorney, provides among other things, the following: “For purposes of this Statement, I, name of worker, hereby agree to be responsible for the payment of all employment taxes, including income, self-employment and Medicare taxes as well as any state employment taxes in connection with the services I provide to Princeton.” “I further represent and warrant that I am an independent contractor,and as such, am responsible for my own health insurance.”
The Statement further prohibits new hires from working more than 10 hours a week for another landscape design firm and also limits the days in which the individual is permitted to perform the service to Saturday and Sunday. Finally, the Statement prohibits a worker from commencing a legal action in any Federal or State Court in the event of a dispute. Instead, any dispute between Princeton and any worker must be submitted to binding arbitration.
Prior to starting work each individual is required to: (i) attend the company’s webinar entitled “Landscaping dos and don’ts;” (ii) submit to a criminal background check, credit report, and DMV report as well as a drug and alcohol test.
At the end of each year, Eric’s accountant prepares Form 1099 Misc. These forms are mailed to each individual who works for Princeton.
Each job starts with Eric either receiving a call or a website inquiry from a potential customer who wants to engage Princeton. The customer generally, but not always, is interested in a new landscaping design for a new home or a landscape makeover for an older home. Eric initially meets with the customer to determine the specifics of what the customer is interested in. Eric, with the assistance of the customer, establishes a budget and reviews photos of various designs that the customer finds appealing. Eric concludes the initial meeting with the customer by taking measurements and photos of the customer’s property and ordering a property survey.
Eric then goes back to the office and reviews the information and photos from the initial visit with the landscape architect. Eric provides the landscape architect with instructions as to the type of design the customer is interested in and the materials selected, together with upgrades and a customer’s budget. From this information, the landscape architect prepares preliminary drawings and also prepares, with the assistance of the company’s estimator, a cost sheet which will be used for the preparation of a proposal for the customer. Once Eric approves the drawings and costs, he prepares a proposal and meets with the customer to review the proposal. If the customer approves the proposal, Eric then prepares a formal contract which he and the customer sign.
Among the workers hired, Eric hires a landscape architect named John, who is responsible for providing landscape design drawings for Princeton’s customers. Like all other Princeton new hires, John is listed on Princeton’s website in the About Us Tab as a “Team Member,” with a description of his academic and professional qualifications. The website’s content also contains the following assertion: “unlike other companies, we do not outsource our work.”
John receives a copy of the Handbook, and signs the document acknowledging he has read the Handbook, understood its contents and agrees to be bound by its terms. John also signs the Independent Contractor Statement.
Princeton has now been in business for five years and the business is flourishing. Eric now has fifty people working for him, all of whom he designates as independent contractors. Princeton’s original office manager resigns to accept a position with a competitor, so Eric hires a new office manager. After reviewing the manner in which Eric is classifying his workers, the new office manager sends Eric an email stating in part: “you cannot arbitrarily treat your workers as independent contractors.” The email further provides: “my last employer got into a lot of trouble doing the same exact thing.” Eric dismisses the office manager’s warning and continues business as usual.
Princeton business is able to grow due, in part, to its competitive advantage. Unlike its competitors, Princeton does not withhold employee income tax, nor does Princeton withhold the employee share of Social Security and Medicare Tax. Since Princeton treats its workers as independent contractors, Princeton also does not pay its matching share of employee Social Security and Medicare taxes nor does it pay any unemployment taxes, provide health insurance to its workers or carry Workers Compensation Insurance. As a result, Princeton is almost always the lowest bidder on jobs, resulting in a disproportionate number of contracts being awarded to Princeton.
The IRS Makes Its Case
In 2008 the financial markets crash, in part due to subprime mortgage practices and overvalued real estate. The crisis results in a halt to most new construction and a dramatic increase in foreclosures, resulting in an oversupply in the housing market. The financial crisis also causes many existing homeowners to forego making any capital improvements.
In response to market conditions, Eric lays off half of his workers, including John. The laid off workers promptly file claims with the State of New Jersey for unemployment benefits. The claims are filed despite the fact that each worker signed the Independent Contractor Statement. Eric receives the standard Notice of Claim from New Jersey and files an objection with the State, arguing that the workers are independent contractors. A plenary hearing is held by the State of New Jersey, where it is determined the workers are employees and therefore, entitled to Unemployment Benefits.
The IRS becomes aware of the recent decision by the State of New Jersey through a local Princeton Newspaper and by reviewing social media posts by Eric. As a result of the information, the IRS commences an examination of Princeton’s books.
At the conclusion of its examination, the IRS determines that the individuals performing services on behalf of Princeton from 2005 to 2008 were improperly classified as independent contractors, notwithstanding the fact that each worker signed the Independent Contractor Statement. The IRS also interviews the office manager, reviews correspondence and the assertions contained on Princeton’s website and emails. The IRS learns that Eric was aware of the issue, based upon the email from Princeton’s office manager to Eric. They also conclude there was no reasonable basis for classifying Princeton’s worker as Independent Contractors. The IRS assesses $750,000 in unpaid payroll taxes against Princeton for the tax years 2005-2008. The IRS also levies the 75% civil fraud penalty against Princeton.
Following the assessment, several months ago, Eric received notices from the IRS, but fails to respond or make payment arrangements. Since Princeton is unable to satisfy the outstanding balance in the amount of $1,312,500,the IRS assesses Eric with the Trust Fund Recovery Penalty and moves against Eric’s personal assets.
Eric’s conduct ultimately results in a referral to the Criminal Investigation Division, an indictment and a plea agreement. Eric is sentenced to 18 months in a federal facility. While imprisoned Eric’s wife files for divorce and relocates to Ohio with the children. After serving out his sentence, Eric is released. On most days today you can find Eric at his fruit and vegetable stand in South Jersey.
The preceding story is based upon an actual case and illustrates the consequences associated with knowingly using an incorrect classification as well as the collateral damage to family and reputation.
The takeaway from this story is obvious: If you own and operate a business and have deliberately classified your workers as independent contractors, you are probably in trouble.
Each business needs to analyze and correctly determine whether the individuals providing services on its behalf are employees or independent contractors. The general rule is that if your workers are classified as employees, then you are required to withhold income taxes, withhold and pay Social Security and Medicare Taxes, and pay unemployment taxes to the Internal Revenue Service. Furthermore, a business who classifies its workers as employees is required to account for and prepare payroll tax returns. Depending upon the circumstances you may also be required to provide medical insurance for your employees as well as carry workers compensation insurance.
In contrast, you generally do not have withhold or pay over to the IRS any taxes related to payments made to independent contractors.
How to Properly Classify Workers as either Employees or Independent Contractor
Trying to correctly define an individual’s status as either an employee or an independent contractor is not an exact science. Instead, each business must weigh numerous factors in making a determination in the context of the entire relationship between the business and the individuals who perform services on its behalf. In general, the more control exercised over an individual by a business, the more likely the individual is an employee. While there is no hard and fast rule or specific set of factors that will dictate classifying an individual as either as an employee or an independent contractor, the presence or absence of certain factors between a worker and the business, may tip the scale in one direction or the other.
The classification as an employee versus an independent contract can be traced to the evolution of the master servant and principal-agent relationships under the Common Law.
THE RELATIONSHIP BETWEEN THE BUSINESS AND THE INDIVIDUAL PERFORMING THE SERVICE
The IRS will examine any information that demonstrates either a certain level of control or the absence thereof. Facts developed under the Common Law, are separated into three categories:
- Behavioral Control. In determining whether the payer has control over the worker’s actions, The IRS will look at:(i) whether the payer provides any specific training or instruction to the worker; (ii) whether the worker receives his or her assignments from the payer or is free to select which assignments to accept or reject; (iii) whether the payer determines the methods by which the work is performed; (iv) whether the payer requires the individual providing the services to prepare reports, time sheets or other records, and if so, whether the payer determines the type of report and manner in which the report is prepared; (v) whether the individual performing the services is required to contact the payer in the event of a problem or complaint; (vi) whether the payer dictates the worker’s daily routine, such as his or her schedule or hours; (vii) whether the payer determines the location where the worker will provides the services; (viii) whether the worker is required to attend meetings, and if so, whether there are any penalties for failure to attend; (ix) whether the worker provide the services personally; and (x) if additional manpower is required to perform the services, whether the payer has the exclusive authority to hire and determine the pay rate for any additional manpower.
- Financial Control.The IRS will also examine the facts to determine whether the payer exerts financial control over the worker. In this regard, the IRS will consider: (i) whether the worker provides any supplies, equipment, materials or property in the performance of the services; (ii) whether the worker leases any equipment, space or facilities in connection with the performance of services; (iii)whether the worker incurs any expenses in the performance of his or her work, and if so, whether the worker is reimbursed; (iv) whether the worker receives a salary, commission or hourly wage or is compensated in a lump sum or based upon piece work produced; (v) whether the worker has a drawing account, and if so, how often how often can the worker draw on the account; (vi) whether the customer pays the worker or the firm; (vii) whether the firm carries workers’ compensation insurance on the worker; (viii) whether the worker or the firm establishes the level of payment for the services provided or products sold; and (ix) whether the worker has any financial risk or risk of loss beyond the normal loss of a salary.
- The Relationship of the Worker and Firm. In determining the relationship between the worker and firm, The IRS will examine: (i) whether a written contract between the payer and worker exists. However, the existence of a contract will not dictatea particular classification. Instead, the IRS will look at how the parties work together; (ii) whether the payer provides benefits on behalf of its workers, such as medical insurance, pension plan, paid vacation, sick days and disability insurance; (iii) whether the individual is hired for a project for a specific period or whether the relationship is expected to continue indefinitely; and (iv) whether the worker provides services that are key aspects of the business.
There are four different classifications for individuals that perform services on behalf of a business.
An individual is generally considered as an independent contractor if the only control the payer exercises over the individual is control over the result. With an independent contractor, the payer lacks the authority or the ability to control what will be done and how it will be done. Examples of independent contractors include doctors, dentists, lawyers, veterinarians, accountants, contractors, subcontractors, public stenographers and auctioneers who offer and provide their services to the public, as opposed to a particular payer. The IRS will always focus on the relationship between the payer and the one performing the services, irrespective of the title given to an individual. “Just because you call it a duck, that doesn’t mean it’s a duck.”
If the individual is classified as an independent contractor, the payer is not required to withhold federal income tax, nor is he required to withhold the employee’s share of Social Security and Medicare tax or make matching employer contributions.
COMMON LAW EMPLOYEE
An individual is a common law employee if the payer has the ability to control what will be done and how it will be done. The most significant factor present in the IRS classification of an individual as an employee is when the payer has the right to control the details of how the services are performed. However, just like with the independent contractor, the IRS will look at the relationship between the payer and the individual performing the services. The more the payer controls the details over defining the services (what will be done) and manner in which the services are performed (how it will be done), the more likely that the IRS will consider the individual an employee. An example of an employee would be a dental assistant, a nurse working for a hospital and a health club office manager.
The IRS will examine all the evidence to indicate whether the payer exercised behavioral or financial control over the individual and will also scrutinize the relationship between the payer and worker.
Just like with the independent contractor, the substance of the relationship, overrides a title.
The IRS defines a Statutory Employee as an individual who is classified under the Common Law as an independent contractor, who falls within the following four categories:
- A driver who distributes beverages (other than milk), meat, vegetable or bakery products or an individual who picks up and delivers dry cleaning, if the driver is the payer’s agent or is paid on a commission basis;
- A Life Insurance sale agent who is employed full time and whose principal business activity is the sale of life insurance, annuity contract, or both primarily for one life insurance company;
- An individual who works at home on materials or goods provided by the business in accordance with specifications provided by the business. Following completion, the goods or materials must be returned to the business or a third party designated by the business; and
- A traveling or city salesman, who is employed full time for a business and engaged in taking and turning in orders received from wholesalers, retailers, contractors or operators of hotels, restaurants or other similar establishments. The work performed by the salesperson on behalf of a business must also be the salesperson’ principal business activity. The goods sold must be sold for either resale or used in the buyer’s business operation.
If the independent contractor falls within any of the preceding four categories, then he or she is treated as a Statutory Employee for purposes of withholding Social Security and Medicare taxes, provided the following three conditions are met:
- The service contract expressly or implicitly provides that substantially all the services to be performed are to be performed personally by the independent contractor;
- The independent contractor does not have a substantial investment in the equipment and property used to perform the services; and
- The independent contractor performs the services on a continuing basis for the same business.
NON STATUTORY NON-EMPLOYEES
Statutory Non-employees are limited to three classes, including direct sellers, licensed real estate agents and certain companion sitters. Generally, direct sellers and licenses real estate agents are considered independent contractors for purposes of income and employment tax purposes, provided the following two conditions are met:
- The compensation for the services provided by either direct sellers or license real estate agents must relate to sales or output and cannot be based upon the number of hours worked; and
- The second condition requires that a direct seller or licenses real estate salesperson perform their services, in accordance with a written contract that provides they will not be treated as employees for Federal tax purposes.
- Finally Companion sitters who are not employees of a companion sitting placement service are generally treated as independent contractors.
Since each situation is different, it is advisable to meet with a capable tax attorney to discuss the probable classification for each worker by the Internal Revenue Service. If it is still unclear, after reviewing all of the facts, it may be advisable, with the assistance of counsel, tofile Form SS-8 (Determination of Worker Status for Purposes of Employment Taxes and Income Tax Withholding).
The takeaway from the Princeton case study and the discussion that follows is this: A business that attempts to game the system, by unreasonably classifying a worker improperly, may quickly find itself in a world of hurt and subject to tax, interest and penalties. In some cases, the assessments, if substantial, can result in the assessment of the 75% civil fraud penalty and may threaten the very existence of the business as a going concern.
Since classification decisions are usually made by an individual or a group of individuals, principal shareholder, officer, directors or other individual with actual or implied authority to act on behalf of a firm, some may be under the mistaken belief that they are immune from personal liability for any unpaid payroll taxes. Think again!
An individual or other party, whom the IRS designates as a responsible person and who willfully, fails to account, withhold and pay over to the IRS any income and employment taxes may be subject tothe assessment of the Trust Fund Recovery Penalty. The predicate for such an assessment is based upon the breach of a fiduciary duty to the IRS to safeguard the “trust funds.”
The number of recent prosecutions by the Department of Justice, Tax Division, as well as press releases and other public statements from the IRS, clearly signal that employment taxes are a top priority for the Government.
Tax cheats will be pursued vigorously, irrespective of the amount in question, and in addition to the imposition of civil and criminal penalties, may be subject to criminal prosecution.
If you have been improperly classifying the status of your workers as independent contractors, you may be at risk. Likewise, you are also at risk, if you have recently received an examination notice from the IRS, indicating their intention to audit the firm with respect to classification of your workers or if you have been contacted by the IRS and requested to appear for an interview. In either event, you should immediately contact a tax attorney to review your particular case to discuss alternatives for coming into compliance and possible defense strategies.
© Anthony N. Verni, Attorney at Law, Certified Public Accountant. 10/2/2016