Business owners must beware costly tax penalties when using independent contractors
While the use of independent contractors is a popular way of controlling expenses, there can be a steep downside - back taxes and costly penalties when the Internal Revenue Service reclassifies self-employed workers as employees. Many health club owners believe that personal trainers and group-cycling instructors are too small a target to be the subject of an audit but, as Edward H. Hernandez, associate professor of management at California State University-Stanislaus, says, "Many business operators are simply not knowledgeable about the law."
The risk of running into a problem is high, because the IRS has not provided a clear-cut definition of what constitutes an independent contractor. "Businesses are often shocked to learn that people who perform services for them are their employees in the eyes of the IRS and state unemployment insurance departments," says Nancy E. Joerg, an employment attorney with the law firm of Wessels & Pautsch in St. Charles, Ill. One audit by the federal or state authorities usually triggers action by the other.
In determining whether independent contractors are classified legitimately, an IRS agent's inquiry will focus on the 20 questions that follow. Several are obviously not relevant to the health and fitness industry; keep in mind, also, that it is not necessary to "pass" all of them, or even a specific number of them. The questions function as a balancing test, with potential taxes and penalties hanging in the balance:
1. MUST THE WORKER FOLLOW YOUR INSTRUCTIONS AS TO HOW WORK IS TO BE PERFORMED? This question is listed first because in some ways it is the most important. It cuts to a fundamental element of IRS reasoning that appears in many of the other questions that follow - the more control you have over the activity of a worker, the more likely it is that you have an employee on your hands.
2. DO YOU TRAIN THE INDIVIDUAL? This can indicate you have control over the person. Once again, in the eyes of the IRS, the presence of control implies an employment situation.
3. ARE THE WORKER'S SERVICES CRITICAL TO THE CONTINUATION OF YOUR BUSINESS? If so, it follows that your business will be more likely to attempt to control such labors. The IRS says this implies the person is an employee.
4. DO YOU REQUIRE THAT THE INDIVIDUAL PERFORM THE WORK PERSONALLY?
5. DO YOU HIRE ASSISTANTS FOR THE INDIVIDUAL? Neither of these are of much relevance to a health club owner. A true independent contractor, according to the IRS, would be able to assign tasks to others and hire and fire assistants without your intervention.
6. DO YOU HAVE A CONTINUING RELATIONSHIP WITH THE INDIVIDUAL? Even if work is performed at irregular intervals, the fact that you use the individual's services over a long period of time is one factor that tends to indicate an employment status.
7. DO YOU DICTATE WHAT HOURS THE INDIVIDUAL WORKS? Suppose you insist that the individual show up for work at a certain time. Or suppose you state that the person must work a set number of hours each day. This implies control over an employee.
8. DO YOU REQUIRE THAT THE INDIVIDUAL SPEND THE ENTIRE WORKING DAY ON YOUR PROJECTS?
9. DOES THE INDIVIDUAL WORK ON YOUR PREMISES? Well, yes - two more questions of questionable relevance to the health and fitness industry. FYI: According to typical IRS reasoning, an independent contractor should be free to work for other businesses. The IRS puts particular emphasis on the latter factor if the work is of such a nature that it could be done just as well at another location.
10. DO YOU DICTATE THAT WORK BE DONE IN A CERTAIN SEQUENCE? The IRS says this would imply a measure of control over the worker and, therefore, an employment situation.
11. DO YOU REQUIRE REPORTS OF WORK ACCOMPLISHED? If you insist that the worker submit oral or written reports - including, potentially, accident or equipment maintenance reports - this suggests, to the IRS, a degree of control.
12. DO YOU PAY BY THE HOUR, WEEK OR MONTH? Periodic payments can indicate an employment situation to the IRS. The exception is if such payments are simply installments in a lump-sum agreement for a project fee, a typical arrangement in an independent contractor relationship. By contrast, payments by project or commission payments generally lean toward independent contractor status.
13. DO YOU PAY THE INDIVIDUAL'S BUSINESS OR TRAVEL EXPENSES? Reimbursement for business and travel expenses - a worker's attendance at a conference, for example, as part of his or her continuing education - may imply a degree of control over that individual's activities. The IRS feels the party who ultimately pays the expenses will have some say over a ceiling of expenses for each category of expense, and thus over the activities of the worker.
14. DO YOU FURNISH THE WORKER'S TOOLS? If the worker uses your fitness equipment and office supplies on the job, this implies an employer-employee relationship. A true independent contractor would possess a set of tools for performing similar tasks for other businesses. Many employment attorneys believe that satisfying this requirement is the most important for club owners hoping to keep the IRS at bay. Personal trainers, they say, should invoice clubs where they work, with the clubs charging them a reasonable fee for using the facility.
15. DOES THE WORKER DEPEND ON YOUR INVESTMENT IN WORKPLACE AREAS TO GET THE JOB DONE? If the worker has invested significant money in an office, this implies independent-contractor status.
16. DOES THE WORKER HAVE NO RISK OF LOSS FROM THE RESULTS OF THE SERVICES RENDERED? If the worker does not incur the risk of loss normally associated with running an independent business, this implies an employment relationship. An independent contractor can realize a profit or a loss.
17. DOES THE INDIVIDUAL WORK ONLY FOR YOUR BUSINESS?
18. DOES THE INDIVIDUAL FAIL TO OFFER SERVICES TO THE GENERAL PUBLIC? A worker who is engaged only by your business may well be an employee. By contrast, an independent contractor would pursue the prospecting normally associated with an autonomous business. Employment attorneys suggest that club owners get and file copies of the worker's advertisements or brochures.
19. DO YOU HAVE THE RIGHT TO FIRE AN INDIVIDUAL?
20. MAY THE WORKER QUIT AT ANY TIME WITHOUT INCURRING A LOSS? Obviously, independent contractors can quit or be fired - but to the IRS, holding the threat of dismissal over a worker if instructions are not followed suggests you are an employer. Similarly, a worker who quits without assuming a liability for doing so is often seen to be an employee.
What is important in this case is to have a written or oral agreement - written is better - that provides the grounds by which the worker may quit or be fired. As is typical in the largely semantic predicament of working with independent contractors, the more you can document, the better.
How can you protect yourself? If you are able to hire self-employed staff through a third-party payroll service that employs those individuals and takes care of tax withholding and reporting, that's an effective method of passing on the headache. That's more of a fix for big business, unfortunately. For health club owners, the best you can do is let 'em do it their way: Don't provide instructions, tools or office space, or reimburse expenses for individuals you have classified as self-employed workers.
Again, when dealing with the IRS's 20 questions, remember that no formula exists for establishing an employment relationship. In some cases, a single "yes" answer can indicate that an individual is an employee. In other cases, some of the questions may be answered "yes" without incurring a determination of employment. Most often, the IRS weighs all of the questions in combination prior to coming to a determination.
Go over the questions with your attorney to determine the status of your workers. "For the employer using independent contractors," warns Hernandez, "there are many ways to go wrong."