Lesson From The Tax Court: Distinguishing Employees From Independent Contractors

Pro Publica has proudly proclaimed that “If You’re Getting a W-2, You’re a Sucker.”  I know lots of workers who would strongly disagree.  For them, being a W-2 worker (a/k/a “employee”) is far more beneficial than their realistic alternative, which is being a 1099 worker (a/k/a “independent contractor”).  The Pro-Publica story was channeling this Brookings Institution study which noted how business owners can often hide their income but workers cannot because their employers rat them out with W-2s.

But most workers have no realistic choice.  Just ask your next Uber or Lyft driver.  For them, as for many others in various industries—from child-care to health-care to landscaping and construction—the choice is not whether or not to hide income.  Their choice is only whether their income gets reported to the IRS on a Form W-2 or a Form 1099.  The upside of being an employee is lower employment taxes and eligibility for unemployment benefits.  The potential downside is no §199A and no ability to deduct unreimbursed job expenses, given the current nastiness codified in §67(g).

And the choice of status is often on the employer.  Employers must decide whether and when to treat their workers as employees or as independent contractors.  Today’s lesson shows how they might be on the hook if they make the wrong classification.  Pediatric Impressions Home Health, Inc. v. Commissioner, T.C. Memo. 2022-35 (Apr. 12, 2022) (Judge Greaves), teaches us how Tax Court distinguishes employees from independent contracts.  It also shows us a potential safe harbor that employers can use to escape the unpaid obligations if it turns out they erroneously classified employees as independent contractors.  Details below the fold.

Law: Structure of Employment Taxes
The structure of employment taxes creates some incentives for employers to classify their workers as independent contractors and not as employees.  Similarly, it creates some incentives for workers to want to be classified as employees and not independent contractors.  Let’s take a very basic look.

The Federal Insurance Contribution Act of 1954 (FICA), 68A Stat. 415, created the current taxing structure in Chapter 21 to support Social Security and Medicare benefits.  Currently, §3101(a) imposes on employees a flat income tax of 6.2% of wages they receive.  The tax funds "old-age, survivors, and disability insurance" (OSDI).  Section 3011(b) imposes a flat income tax of $1.45% on wages to fund "hospital insurance" (Medicare).  Employers are required to withhold these taxes from wages paid and pay them over to the government on a regular basis.  §3102.

Section 3111 imposes a similar set of taxes on employers, only these are excise taxes imposed on the act of hiring employees: 6.2% of the wages paid supports OSDI and 1.45% supports Medicare.  Employers pay these taxes at the same time they pay over the taxes withheld from their employees’ wages.

Thus, if a worker is an employee, the worker must pay a flat income tax, totaling 7.65% of their wages.  And the employer shoulders another 7.65% excise tax on the same wages.  The government thus collects a total of 15.3% of the wages paid.

If a worker is not an employee, however, then two consequences follow.  First, the employer does not have to withhold or pay over any amounts and is not obligated to pay the excise taxes!  Second, the Self Employment Contributions Act, 68A Stat. 353 (SECA), shifts the tax obligations to the workers.  It treats their income as arising from a trade or business and imposes both the employee share and the employer share of OSDI and Medicare taxes on (totaling 15.3%) on their “net earnings from self-employment,” a statutory term of art which basically means gross income less business deductions allowed.

Finally, the last piece of the puzzle is that employers who employ employees are also subject to both federal and state unemployment taxes to support the unemployment benefits their employees may be entitled to receive under certain circumstances.  See, e.g. the Federal Unemployment Tax Act (FUTA), 68A Stat. 429, codified in Chapter 23, §§3301-3311.  In contrast, self-employed workers are not subject to unemployment taxes because, hey, they are not entitled to unemployment benefits.  So an employer who employ an “independent contractor” is also freed from paying FUTA taxes.

Yes, I’m skipping over lots of stuff (like nuances in rate structure), but I think this is the gist of what folks need to know for today’s case.  I invite readers who think I’ve missed something vital to please put it in the chat.  I am always willing to be corrected.  Just be polite.

Law:  The Indeterminate Multi-Factor Test for Determining Employee Status
It’s not always easy to know whether a worker is an employee or independent contractor.  Courts routinely say it’s a facts-and-circumstances determination.  Weber v. Commissioner, 103 T.C. 378, 386 (1994), aff'd per curiam, 60 F.3d 1104 (4th Cir. 1995).  As does Treas Reg. 31.3121(d)-1 (“Who are employees”).  You can find a long list of factors in Publication 15-A.

Courts have different ways of grouping all the relevant factors.  For example, the Supreme Court has listed factors as degrees of control, opportunities for profit and loss, investment in facilities, permanency of the relationship, the skill required of the worker. United States v. Silk, 331 U.S. 704 (1947).  Lower courts have added the consideration of whether the work performed is an integral part of the employer's operation.  United States v. Lauritzen, 835 F.2d 1529 (7th  Cir. 1987); Hobbs v. Petroplex Pipe & Constr., Inc., 946 F.3d 824 (5th Cir. 2020).

I like how the IRS creates three broad buckets o’ factors in Publication 15-A: (1) Behavioral Control; (2) Financial Control; and (3) Type of Relationship.  I think the factors going to control are generally the most important ones with that third bucket being more of a set of miscellaneous tie-breakers.  See Weber, supra, at 390 (“Normally the control factor is the most persuasive factor in determining whether an employment relationship exists.”).  I will discuss each, briefly.

(1) Behavioral Control
A worker is an employee when the employer has the right to direct and control the work performed by the worker, even if that right is not exercised.  See e.g. James v. Commissioner, 25 T.C. 1296, 1301 (1956)(doctor who worked for two hospitals was employee of each one).  That means both more and less than just telling someone when to show up.  It can also mean controlling what tools to use or where to purchase supplies and services, giving instructions about how to perform the work, or having evaluation systems that measure the details of how the work is done.  In addition, the IRS considers that training on how to perform the work is strongly indicative of employee status.  See Pub. 15-A.  In contrast, simply acting as a dispatcher and job coordinator does not rise the requisite level of behavior control.  See Santos v. Commissioner, T.C. Memo 2020-88 (apartment cleaning company’s workers were independent contractors and not employees because company did not have the right to control the manner and means by which the cleaning work should be accomplished or whether the workers could hire out assistants). As the Fifth Circuit explained, there must be a real independence: “a lack of supervision of the individual over minor regular tasks cannot be bootstrapped into an appearance of real independence.” Hobbs v. Petroplex Pipe & Constr., Inc., 946 F.3d 824, 830 (5th Cir. 2020) (internal citations omitted).

(2) Financial Control
A worker is likely an employee when the employer exercises such significant financial control over the worker that, as a matter of economic reality, the worker cannot be said to be in business for themselves, but is dependent on the employer. See e.g. Thibault v. Bellsouth Telecomms., Inc., 612 F.3d 843 (5th Cir. 2010).  Indicia of independent contractor status include: if the worker is realistically able to perform similar work for others; if the worker can develop their own client base; if the worker absorbs their own investment cost in equipment used to perform the work; if the worker incurs unreimbursed expenses; if the worker is paid by the job with a flat fee.  But if the employer is the one investing the tools, training, and other costs underlying the work, or if the worker’s employment prevents other economic opportunities in a meaningful way, or if the worker’s bottom line is dependent on the employer's actions, then these factors support employee status.  See Hobbs, supra, at 833 (“under the economic realities test, it is not what the [workers] could have done that counts, but as a matter of economic reality what they actually do that is dispositive.”  The court then found “ample evidence...that the work schedule imposed by Petroplex severely limited the pipe welders’ opportunity for profit or loss.”).

(3) Relationship
This is the idea of that parties’ intent.  In considering the parties’ intent the IRS will look at factors such as: (1) written documents that define the relationship; (2) whether the employer provides benefits such as insurance, retirement plans, vacation pay or sick pay; and (3) whether the relationship is a one-off for a particular project or period of time, or is expected to continue indefinitely.

In addition, the history of the relationship can be important.  If the taxpayer has a history of treating the workers as independent contractors, then there is an off-code provision that gives taxpayers a safe harbor from liability for past employment taxes.  It’s §530 of  the Revenue Act of 1978, 92 Stat. 2763, 2885.  As Judge Greaves explains, §530 relief is available when the taxpayer has a reasonable basis for classifying the workers as independent contractors and has historically and consistently treated the workers as independent contractors.  Op. at 11-12, citing to Charlotte's Office Boutique, Inc. v. Comm'r of Internal Revenue, 121 T.C. 6 (2003).

Facts
Pediatric Impressions Home Health, Inc. (“PIHH”) was in the business of providing in-home nursing services to kids who had special needs.  To provide these nursing services, PIHH employed nurses.  Before 2016, PIHH had treated the nurses as employees.  But in 2016 it decided to treat them as independent contractors.  The IRS audited for 2016, 2017 and 2018 and decided the nurses were really employees.  So PIHH was on the hook for three years of unpaid employment taxes.  Let’s see what we learn about why Judge Greaves has no difficulty agreeing with the IRS: the nurses were employees and not independent contractors.

Lesson:  An Easy Call When All The Factors Point To Same Conclusion
While Judge Greaves does not group the factors like I do above, I think his opinion nonetheless shows how the factors in this this case fall neatly into all three buckets and each bucket points strongly in the same direction: the nurses were employees.

(1) Behavioral Control
There were some facts here that pointed to independent contractor status.  Nurses were assigned to particular patients, were responsible for obtaining and implementing the doctor’s plan of care for each patient, and were not supervised in their day to day activities in real time.  Nurses were free to accept or refuse particular assignments to particular patients.

Almost all the other facts, however, pointed to employee status.  Before hiring a nurse, PIHH performed background checks and administered a skills assessment.  PIHH not only assigned the nurses to the patients but also had sole authority to reassign to another patient.  While a nurse could refuse to provide services to an assigned patient, the nurse risked losing future assignments or even termination for doing so.

PIHH required and provided continual training at its offices on both administrative and medical topics.  That would be a big one for the IRS.

While there was little in-person supervision, PIHH closely and continuously reviewed each nurse’s performance, requiring each nurse to submit case notes and incident reports.  Nurses were not free to deviate from the assigned plan of care and PIHH both monitored what they were doing and controlled how they were doing it.

Finally, if a patient had a complaint about a nurse, it was PIHH that would hear the complaint and decide how to resolve it, “which might include counseling, disciplining, reassigning, or terminating the nurse.” Op. at 9.

(2) Financial Control
The main fact here supporting independent contractor status was that the nurses were not prohibited from obtaining other work.  Nurses were also eligible for some performance-based bonuses.

But everything else added up to the conclusion that PIHH exerted significant financial control over these workers and one could not realistically say the nurses were “independent” of PIHH.

First, PIHH controlled their schedules.  Sure, the nurses could say no, but that jeopardized future assignments.  Similarly, the nurses were prohibited from hiring their own help.  If they needed substitutes or assistance, they had to work it through PIHH.  Second, the nurses had little capital investment in their jobs.  PIHH supplied their training, insurance, equipment and reimbursed them for out-of-pocket expenses.  Third, nurses had little ability to participate in the business or to control their own opportunities for profit.  They were on a fixed hourly rate.  All payments for services were made to PIHH.  The nurses were not allowed to subcontract.  They were not allowed to develop business for themselves or for PIHH.  PIHH “neither required nor permitted them to find new patients.” Op. at 11.  The financial control bucket is not a tough call.

(3) Relationship
I am guessing the employment document probably labeled the nurses as independent contractors and that the nurses signed a document agreeing to that status.  The strongest fact pointing to independent contractor status in this bucket, however, was that PIHH “did not offer the nurses benefits such as health insurance, paid time off, or retirement benefits....” Op. at 4.

Those facts, however, were outweighed by two other facts, as Judge Greaves details it.  First, Judge Greaves repeatedly notes the unequal employment relationship: the employment document allowed PIHH to fire the nurses at will but required the nurses to give 2 weeks notice.  That’s a typical provision indicating a employee relationship since employers want and need time to obtain replacement labor but unemployment benefits mitigate the harshness of showing up for work one day and learning that one is fired.  Second, the nurses were hired on a permanent basis for an indefinite period.  Judge Greaves again makes multiple mention that PIHH “normally inform[ed] the nurses that they were ‘employed’ on a ‘full-time’ basis....” Op. at 3.  Well, if you are telling your workers they are full-time employees, that sure cuts against you being able to tell the IRS differently!

Finally, perhaps the biggest fact in this relationship bucket was that PIHH treated all these nurses as employees for the years before 2016.  Judge Greaves specifically finds that “the jobs performed and the services provided by the nurses, including petitioner’s supervision thereof, however, remained the same following this change in employment status.”  Op. at 5.  Not only does this weigh against the treatment of the nurses as independent employees, it also precludes any relief under §530 of the Revenue Act of 1978.

Bottom Line: This seems to be a pretty easy case.  And easy cases sometimes make good lessons.

Coda: Some weeks the Tax Court puts out more useful lessons than I can blog about.  About two years ago I considered blogging Santos v. Commissioner, supra.  I recommend that case to readers as a good counterpoint to today’s case.  It came out the opposite of today's case: the Court found that the taxpayer had properly classified her workers as independent contractors.  I won’t bore you with the details but it’s a nice short lesson that illustrates the highly factual nature of the employee/independent contractor determination. 

Bryan Camp is happy to be a W-2 Employee of Texas Tech University School of Law, as the George H. Mahon Professor of Law.  He invites readers to return each week to TaxProf Blog for another (hopefully useful) Lesson From The Tax Court.