If it Looks and Quacks like a Duck, It's a Duck

By Mike Raymond

Author note: Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as specific tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, it is not guaranteed.  Please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.  The reader must rely upon his or her own professional advisor before making decisions with respect to these matters.

Imagine a dance studio in your town that has a teacher running dance classes on a studio-designed schedule for approximately four hours per week.  This teacher does not operate under a business name, does not advertise as a separate business, and does not keep business records. The teaching is done at the studio and all equipment (props, stereo equipment and CDs) are paid for and provided by the studio.  When this teacher is sick or unavailable to teach, the studio, not the teacher, finds the suitable replacement.  Imagine also that when there is a convention to attend, the studio picks up the tab for the teacher to be there.  Simply put, this teacher is an integral part of the studio—has been there for years—and receives an hourly rate for services rendered.  Let’s also imagine that this dance instructor is free to teach at other studios as well as long as it does not interfere with studio responsibilities.

Despite everything, the owner of this studio is convinced this teacher is an “independent contractor.”  In fact, the studio went even further and had the instructor sign a written agreement as if such agreement proves such status (IRS does not have to honor it).  The owner feels confident that it is unnecessary to withhold federal, state, and Social Security (FICA) taxes or pay unemployment or worker’s compensation insurance. The 1099 is sent out each year.  Big bucks for the business are certainly saved, but there is a huge problem. This particular studio has a clear priority on the teaching time by the instructor. The teacher is clearly subject to many restraints and conditions that are indicative of the studio’s control over the instructor’s time.  These factors could indicate the existence of an employer-employee relationship.  If so, the written agreement means nothing since the courts and the IRS have held that “what you call it” does not affect what it really is.

The Internal Revenue Service (IRS) knows quite well that many small business owners sometime misclassify their workers; that is, they are called independent contractors, even though they do not act as such.  The IRS is scrutinizing these relationships more and more since businesses who classify all their employees as independent contractors fail to pay substantial amounts of employment tax.   It should not be a surprise to you the IRS may determine your teachers to be employees and not independent contractors unless they really are independent.

Beware: there are substantial IRS penalties for an obvious misclassification.  If a studio misclassifies its workers, it risks being audited.  If guilty, a business might be required to pay all back withholding taxes plus interest (even if the instructor already paid his or her taxes).  There are also huge fines. The penalty for misclassification alone is 100% of the taxes that should have been withheld for the employee.  That does not even count the fact that the newly-classified “employee could sue you for unemployment insurance, stock options, overtime pay, retirement benefits, disability payments and workers’ compensation.

To avoid making this serious mistake, I suggest you consult with your attorney and ask him or her to complete IRS form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, which asks the IRS to make a determination of the employment status of your workers.  In consultation with your attorney, I suggest you ask yourself the following:

Do I have “behavioral control” over the teacher? Do I have the right to direct and control how my teachers perform their job?  Do I give instructions to my teachers on how I want them to teach my students?

Do I have “financial control” over my teachers?  Am I, the owner, the one who determines if the teacher is paid all at once (lump sum) for a job done, or by the hour, week, month?  Are my instructors guaranteed a regular wage amount for an hourly, weekly, or other period of time?

Do I have an exclusive and ongoing “professional relationship” with my teachers whereby I may even offer some benefits such as health insurance, vacation or sick pay?

To help you determine the true employment status of your teachers, the IRS has made available “The IRS common-law 20 question test.”  

1.       Risk of profit or loss - independent contractors realize a profit or sustain a loss based on their success in performing the work or service.

2.       Continuing relationship - the relationship between an independent contractor and an employer ends when the job is done.

3.       Compliance with instructions - independent contractors cannot be told when, where or how to do the job.

4.       Training - independent contractors do not go through any type of instructional training period with a more experienced employee to learn how to do the job.  Independent contractors specialize in the field in which you have employed them and do not need to be trained.

5.       Personal service required - the right of an independent contractor to substitute another’s services without the employer’s knowledge shows that the employer is not requiring one individual’s personal services.

6.       Integration into business - the success or continuation of the business is not dependent on the independent contractor’s performance of the service.

7.       Control over hiring, supervising, and paying of assistants - an independent contractor maintains control of their assistants.  The employer contacts the independent contractor if there is a problem, and the employer pays the independent contractor for the work done and then the independent contractor pays the assistants directly.

8.       Set hours of work - the independent contractor establishes his/her own hours of work.

9.       A full-time work requirement - an independent contractor has the availability to work for more than one client.

10.   Working for more than one firm - an independent contractor has an established business in which they work for more than one firm.

11.   Worker’s availability to the general public - an independent contractor makes services available to the public on a regular and consistent basis.

12.   Working on the employer’s premises - an independent contractor, unless the nature of the service requires, works off-premises.

13.   Required work order or sequence - an independent contractor does not need to be told in what order to do the job.  They have been contracted with as one that is an expert in this field and do not need to be told how to do the job.

14.   Required reports - an independent contractor is not required to submit oral or written reports.

15.   Payment by the hour, week or month - an independent contractor is paid in a lump sum fee basis when the job is done.  An invoice must be generated to substantiate the payment.

16.   Payment of business or travel expense - an independent contractor is responsible for his/her own business or travel expense.  If paid by an employer, the employer must include in the independent contractor’s 1099, unless you can verify an accountable plan.

17.   Furnishing of tools and materials - an independent contractor has the necessary tools and materials to do the job.

18.   Investment in facilities - if the independent contractor maintains an office on the employer’s premises, he/she pays a rent or lease payment for the office space as well as overhead.

19.   Employer’s discharge rights - an independent contractor cannot be terminated as long as they are fulfilling the contract.

20. Worker’s termination rights - an independent contractor could be held financially responsible for any loss the employer suffered because they did not fulfill their contract.

The IRS recently applied the common law factors to determine that three part-time instructors at a community college were employees, not independent

contractors.  Even though the three had full-time jobs elsewhere, the IRS still determined they were employees of the college because their instruction was an integral part of the college’s business, the college set the class schedules, and the instructors had no investment in facilities and were not compensated based on profit and loss.

To determine whether your teachers are independent contractors or employees is a serious business and tax matter.  No one factor will generally prove the case one way or the other.  But if a preponderance of factors leads you to think what you really have are employees under your supervision and control, I suggest strongly you begin to make plans for your next “employee” picnic.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as specific tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, it is not guaranteed.  Please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.  The reader must rely upon his or her own professional advisor before making decisions with respect to these matters.

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