There appears to be much confusion in the industry regarding the distinction between working as an independent contractor and serving as an employee—an issue coming to the fore as new legislation mandates paying overtime to the latter but not the former.
The confusion is largely due to the fact that two federal agencies use what appear to be different standards to make the determination, and to the complexity of the standards involved. As with many complicated tax rules, the standards are easy to state but hard to apply. In this and subsequent columns I will try again to clarify the application of the rules as they apply to travel agents.
If the worker is an “employee,” the employer is required to withhold income taxes, Social Security tax, Medicare, FUTA (Federal Unemployment Tax Act), and SUTA (State Unemployment Tax Authority). If the worker is an independent contractor, the worker has the responsibility to pay quarterly self-employment tax and all other tax-related obligations; the employer’s obligation is to provide a Form 1099 when annual payments to the worker are at least $600 per year.
Every employer is subject to severe penalties and potential criminal liability for improper handling of tax-withholding responsibilities. And, of course, the failure to properly account for income and pay the required taxes subjects workers to similar consequences. Given the severity of the penalties, one would think the government would have clarified the rules governing who is an employee in a manner that is practical and usable by ordinary business people, but it has not done so and the responsibilities remain. It’s therefore very important to get this right.
In this first column, we will discuss only the Internal Revenue Service approach. The essence of the IRS test is: which party has the right to, or in practice does, control the details of what and how the services are performed? There are three categories of fact-based tests relevant to that determination.
- The first is Behavioral: Does the employer have the right to control what the worker does and how the worker does the job? For example, the employee must work the hours and at places specified by the employer. An easy example is the at-home agent who is required by the agency to actively work on sales between 9 and 5 each weekday. An independent contractor working at home makes his own hours and works wherever she chooses, including a table at Starbucks or in clients’ homes.
- The second set of tests are Financial: Which party controls the business aspects of the worker’s job? How is the worker paid, are expenses reimbursed, who provides tools/supplies? If, for example, the travel-seller worker uses the agency’s offices, including a desk, telephone and computer provided and paid for by the agency, the seller is likely to be treated by the IRS as an employee. If the worker pays a fair-market rent for the use of the agency’s space and equipment, those facts point to the role of independent contractor.
- The third group of tests relates to the Type of Relationship created by the working practices of the parties: Is there a written contract spelling out the relations of the parties, and is the contract followed in practice? The absence of a contract is likely to be fatal to the claim of independent contractor status, but even if there is a contract, you must follow its terms if it is to help you. It is also relevant whether the contract provides for employee-type benefits for the worker (retirement plan, insurance, vacation pay); if so, she is likely an employee. Finally, is the work performed a key aspect of the business? Clearly, selling travel is central to the business of a travel agency. Sales activities must be conducted in a truly independent fashion in order to survive this test.
The IRS guide that discusses the many additional details of these tests is found here.
So much for the IRS approach. In the next column we will discuss the apparently different approach of the Department of Labor, which may not be so different after all. In subsequent articles, we will try to harmonize the various rules into a coherent and achievable course of action for agency owners and independent contractors.