M E M O R A N D U M NO. SAD 02-71
 

TO:	Chief Fiscal Officers/Vice Chancellors
FROM:	Robert L. Powell State Controller
SUBJECT:	Worker Classification (Employee versus Independent Contractor)

The Internal Revenue Service – Greensboro Office has recently contacted the Office of the State Controller concerning workers employed by the State of North Carolina that were not being paid through payroll and were not having employment taxes withheld.  The withholding of employment tax upon a bonafide employee is not at the discretion of management nor is it a consideration of budgetary financial constraints.  If someone is an employee of the State under the various criteria used to make such determination, you must withhold tax and you must issue a Form W-2.  This is true even if the worker is paid through a personal service contract.

The following are various statutes applicable to making a determination of worker status:

1. Section 218 of the Social Security Act,
2. Section 530 of Revenue Act of 1978,
3. The Common Law.

The State of North Carolina entered into a Section 218 Agreement on July 16, 1951.  This agreement is administratively codified in Section 135-19 of the N.C. General Statutes.  The Director of the Retirement System is charged under this statute with the administration of FICA coverage.

Under North Carolina’s 218 agreement, all members of the retirement system are employees for FICA purposes.  Officers of the state and elected officials are also employees for purposes of the FICA tax.

The following services are not subject to FICA tax withholding under Section 218:

1. Jurors and notaries public;
2. Services performed by an employee to relieve him from unemployment;
3. Services performed by a patient or inmate in a state hospital or institution;
4. Services of an emergency nature (responding to floods, blizzards, hurricanes etc.);
5. Services of elective officials comprising governing boards whose duties require not more than 1000 hours of service per year;
6. Services of members of all other boards, commissions, councils and committees whether positions are filled by the Governor or the General Assembly whose duties require less than 1000 hours of service per year; and
7. Students enrolled and regularly attending classes.

Section 530(e)(3) of the Revenue Act of 1978, as amended by the Small Business Job Protection Act of 1996, clarifies that the first step in any situation involving whether the government entity has the employment tax obligations with respect to workers is determining whether the government entity meets the following consistency and reasonable basis requirements before the relief provisions of Section 530 apply:
A) Consistency Test
The government entity must meet both aspects of the consistency test by:
1. filing all required Forms 1099 (reporting consistency), and
2. treating all workers in similar positions the same (substantive consistency).

B) Reasonable Basis Test
The government entity must satisfy one of the following:
1. prior audit safe haven,
2. judicial precedent safe haven,
3. industry practice safe haven, or
4. other reasonable basis.

Meeting the consistency and reasonable basis tests will give the government entity relief from employment taxes with respect to the workers whose status is in question.  Note, Section 530(d) denies relief to certain technically skilled workers who provide services under a three party situation (engineer, designer, drafter, computer programmer, system analyst, or other skilled worker engaged in a similar line of work).

Any worker who is an employee under the common law standard would be an employee for purposes of Section 530 relief (IRC Section 3121(d)(2)).

3. The Common Law
The common law is developed mainly by court decisions.  The basic standard for determining whether a worker is an employee is whether the employer has the right to direct and control the worker as to the manner and means of the worker’s job performance.  That is, whether the government has the right to tell the worker not only as to what shall be done but as to how it shall be done.

The courts have considered many facts in deciding whether a worker is an independent contractor or an employee.  These facts fall into three main categories:
1. Behavioral Control
2. Financial Control
3. Relationship of the Parties

1.    Behavioral Control    Included in this category are facts that show whether the government entity has a right to direct and control how the worker performs the specific task for which he or she is engaged.  This includes evaluation of the following issues.
 

a.

Instructions. The agency must evaluate the extent to which instructions are given.  This may include when to do the work, where to do the work, what tools to use, what workers to hire to assist in the work, where to purchase supplies or services, the ability to hire assistants, what routines or patterns must be used, what order or sequence to follow.  The fact that you require a worker to obtain prior approval before taking certain action is an example of instructions.

b.

Degree of Instructions.  The extent to which the government entity retains the right to control the worker’s compliance with the instructions, and the effect on the worker in the event of noncompliance.  The more detailed the instructions, the more likely the worker is an employee. The nature of the worker’s occupation also affects the degree of direction and control.  Highly trained professionals such as doctors, accountants, lawyers, engineers, or computer specialist may require little training and/or instruction on how to perform their services.  In classifying professional workers, evidence of control or autonomy with respect to the details of how the task is performed tends to be especially important, as does evidence concerning the relationship of the parties.  Generally, such professional workers who are engaged in pursuit of an independent trade, business or profession in which they offer their services to the general public are independent contractors and not employees. Training is another important factor.  An employee may be trained to perform services in a particular manner.  Independent contractors ordinarily use their own methods.

2.   Financial Control     This category includes facts, which illustrate whether there is a right to direct or control how the business aspects of the worker’s activities are conducted.  This includes whether there is a significant investment, unreimbursed expenses, services available to the public, method of payment and the opportunity for profit or loss.

Independent contractors generally seek out business opportunities, advertise, maintain a visible business location, and are available to work elsewhere.  They often are not reimbursed for expenses incurred to perform the work.  An employee is generally paid by the hour, week, or month.  An independent contractor is often paid by the job.  One of the most important criteria is whether the worker can make a profit or incur a loss.

3.    Relationship of the Parties      Courts often look at the intent of the parties.  This is most often set forth in the contract.  The facts and circumstances under which a worker performs services are determinative of a worker’s status.  The designation or description of the parties is immaterial.  The IRS looks to the substance of the transaction, not a label to make a final determination of worker status.

In cases where it is still difficult to make a determination, the intent of the parties in making the contract becomes a more significant factor.  Filing  a Form W-2 usually indicates both parties believe the worker to be an employee.   Providing service through a corporate entity tends to indicate IC status providing corporate formalities are followed and lease one non-tax reason for operating in the corporate form exists.  Providing the worker with employee benefits indicates employee status.  A worker’s ability to terminate work at will indicates employee status, while if work is terminated then payment could be refused or the worker sued for nonperformance indicates independent contractor relationship.

The existence of a permanent relationship between the worker and government is evidence of an employee relationship.  If a worker is engaged with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally evidence of an intent to create an employment relationship.

Other governmental factors may be applicable in addition to the three main common law  categories.  These may include particular state laws, or determinations of state or federal agencies.

OSC Form 319, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding has been redesigned to reflect changes made by the IRS in Form SS-8.  The IRS has attempted to simplify its procedures for making worker determinations.  A copy of OSC Form 319 is attached to this memo for your agency’s convenience.

Should you have questions concerning the above, please call Randy Thomas at (919) 981-5488.  Thank you for your attention to this matter.

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