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A Trigger for Taxes and Penalties: Employee or Independent Contractor Status

April 9, 2014

A Trigger for Taxes and Penalties: Employee or Independent Contractor Status

The hospitality industry hires thousands of workers every year. Some of these workers enter the industry as full- or part-time employees while others are hired as independent contractors. In fact, an increasing number of businesses are addressing their human resource needs by engaging independent contractors due to the advantages involved – including the avoidance of administrative and insurance costs related to the Affordable Care Act. However, it is important to note that the incorrect classification of a worker as an independent contractor as opposed to an employee can have serious tax implications as this is a high tax audit area for the IRS and state employment departments. Employers should also be aware that incorrect classification could lead to forgone credits – while an employer could be eligible for the federal FICA tip credit on tipped employees' income, this would not be the case for an independent contractor.

What are the implications for misclassification? The IRS can reclassify an independent contractor as an employee making the employer now responsible for income and employment taxes, filing delinquent returns, and penalties for late payment and withholding. The repercussions are exacerbated if an employer treats a worker as an independent contractor, the worker is terminated, and they subsequently apply for unemployment benefits. Safe harbors which can allow employers to use the independent contractor status and avoid penalties include a prior practice of treating similar employees as independent contractors and the existence of a prior IRS audit where no taxes were required to be paid. However, the first example—past practices—typically will not hold up in an IRS audit. Instead, it could expose a business to further tax scrutiny.

What Defines a Worker as an Employee Versus an Independent Contractor?

The legal definition of an independent contractor, while not conclusive, has been outlined by various sources including:

·         Common law principles and court decisions

·         The IRS’ “20 factor test”

The Supreme Court has said that there is no single definition that solves all problems relating to the employer-employee relationship of an independent contractor under the Fair Labor Standards Act (FLSA). The Court also said that determination of the relationship cannot be based on isolated factors or upon a single characteristic. Rather, it depends upon the circumstances of the whole activity.

Common Law Principles and Court Decisions

The IRS and many states have adopted common law principles that identify an independent contractor. These principles focus on the level of control an employer has over the service or product being provided by the independent contractor. Many court decisions on employee versus independent contractor issues have also focused on the same characteristics. The level of control is evaluated by the means in which the employer is defining what the contractor is doing and how his/her task will be accomplished. Other factors including method of compensation (such as whether the employer is making consistent paycheck payments to the worker) can point to an employer/employee relationship. Other ways that a worker may be defined as an independent contractor can include:

·         The worker supplies his or her own equipment, materials, and tools

·         All necessary materials needed for the worker to do his/her job are not supplied by the employer

·         The worker can be discharged at any time and can choose whether or not to come to work without fear of losing employment

·         The worker, as opposed to the employer, controls his/her hours of employment

·         The worker’s temporary vs. permanent employment status

·         The nature of work being done as it pertains to the independent contractor’s relationship with the hospitality company. For example, a celebrity chef or mixologist who is providing services to a hospitality venture, but is not integral to the identity of its concept, could possibly be designated as an independent contractor

The IRS’ “20 Factor Test”

The IRS has identified 20 factors that provide direction on whether an individual is an independent contractor or is an employee. No single factor within the list is decisive in establishing a worker’s classification and a worker does not have to meet all 20 criteria to qualify as an employee or independent contractor. Although the focus is on control, the determination of independent contractor versus employee status is based on all of the facts and circumstances surrounding the relationship. Some of the 20 factors include:

·         Level of instruction on when, where, and how work is done.

·         Amount of training related to the methods by which the work is accomplished.

·         Degree of worker integration into the business.

What Does CohnReznick Think?
There are potentially serious tax consequences for hospitality companies if a worker is mis-identified as an independent contractor. The associated financial consequences may not only be limited to retroactive taxes in conjunction with the reclassification. Hospitality companies may also be required to pay penalties for late payment and filing of payroll tax returns and responsibility for workman’s compensation claims.


If you have any questions related to the classification of workers at your hospitality company, our professionals can help. Please contact Gary Levy, Partner and Hospitality Industry Practice Leader, at 646-254-7403 or Marshall Varano, Partner, at 858-300-3424.