Tax exempt organizations face the same worker classification issues as for-profit organizations. When an individual performs services for a tax exempt organization on his or her own (not through another organization) and is compensated for such services, that individual is acting as an employee or an independent contractor with respect to the tax exempt organization. Proper classification of a service provider as an employee or an independent contractor is very important for a variety of purposes, including federal income tax and state workers’ compensation laws. The tests for determining the proper status are often similar, but not identical, at the federal and state levels, and, therefore, care should be taken when there is a question as to proper classification, to comply with both federal and state laws. Note that the proper classification of an individual is generally questioned by the IRS or state agencies when the individual is classified as an independent contractor; thus, if an organization is uncertain as to proper classification, the conservative approach from a tax perspective is generally to classify the worker as an employee.
The IRS previously delineated 20 common law factors it would use to determine the proper classification of a service provider as either an employee or an independent contractor. These 20 factors have been repackaged into three broader categories that comprise the test used by the IRS to classify workers: (1) behavioral control; (2) financial control; and (3) relationship of the parties. These three categories subsume the 20 common law factors and emphasize how important the tax exempt organization’s control over the service provider is in determining whether he or she is an independent contractor or employee.
Structure the relationship clearly upfront, in writing.
A tax exempt organization that seeks to hire independent contractors should have a written independent contractor agreement with such individuals (assuming it is commercially practical). The tax exempt organization should be familiar with the three categories described above (and the 20 factors contained therein), as well as any state law worker classification guidelines, and should craft the relationship to reflect that the individual will have as many indicia of an independent contractor as possible. The terms of that relationship should be clearly articulated in writing in an independent contractor agreement and the individual should have a clear understanding of the tax ramifications of independent contractor status.
Take advantage of IRS’s Voluntary Classification Settlement Program –
If a tax exempt organization determines it has been improperly classifying its employees as independent contractors, the organization may be able to take advantage of a settlement program intended to give employers a fresh start in classifying their workers. The IRS has a Voluntary Classification Settlement Program (VCSP) through which qualifying tax exempt organizations (as well as other employers) can obtain partial relief from federal employment taxes if they properly classify those workers going forward. If a tax exempt organization qualifies for the VCSP, the organization will have limited liability for prior federal employment taxes, not be subject to interest and penalties, and not be subject to an employment tax audit with respect to those workers. The details of the VCSP are contained in Announcement 2011-64, 2011-41 IRB, 09/21/2011. However, note that there are also risks associated with participating in the VCSP, including that it is a federal tax program and provides no protection from state law claims, including state taxes, or from federal wage/hour claims, employee discrimination claims, or employee benefits claims for prior years. Classifying an individual as an employee through the VCSP might encourage states to seek their own pound of flesh due to prior misclassification and might cause reclassified individuals to assert their rights as employees under various employment laws.