Strasburger & Price, LLP Publication

Co-author Farley P. Katz

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Co-written by Anthony E. Rebollo. For a full copy of this article, or to discuss the issues presented, please contact Mr. Katz.

Independent Contractor or Employee?
Understanding and Avoiding Tax Liabilities Based on Worker Classification


San Antonio Lawyer
2nd Quarter 1997


In recent years, the Internal Revenue Service has devoted a great deal of its time and resources to worker classification issues, i.e., whether a particular worker or group of workers should be categorized as independent contractors or employees. The distinction is an important one because, in general, no income and employment tax withholding is required when making payments to contractors, whereas the opposite is true with employees.

The distinction is also an important one for the Texas Workforce Commission (the "TWC"), which was formerly known as the Texas Employment Commission or "TEC." The TWC must examine the same issue on a recurring basis since it is charged with the responsibility of collecting unemployment taxes from employers based on the amount of wages paid to "employees." Payments to independent contractors, on the other hand, would not subject the employer to tax. The definition of "employer" for purposes of the TWC for the most part closely tracks the Internal Revenue Code definition, although there are several differences.

Some have questioned the intensity and frequency of the audits in this area, noting that, regardless of the classification of a worker, the amount of tax imposed and collected by the federal government should be about the same. An independent contractor is required to pay income tax, just as an employee does, and is also required to pay self-employment taxes (the equivalent of FICA). While this argument is correct, it ignores the realities of tax compliance. It is well known that the rate of compliance for tax filings and payments is much lower for contractors than it is for employees, for the primary reason that the taxes of the latter are withheld at the time of payment. By forcing a switch in classification from contractor to employee, thereby triggering "withholding at the source" of the payments to workers, the overall rate of compliance with the tax laws will be increased.

This article describes the various tests applied by the federal and state governments in examining the perennial independent versus employee question, including important recent changes on the federal level included in the Small Jobs Protection Act of 1996. Understanding these different tests is critical because an incorrect classification of workers can, and frequently does, lead to the imposition of large, unanticipated tax liabilities. As discussed below, there are a number of basic methods for successfully resisting an adverse determinations or, at the very least, for minimizing liabilities in the event that an adverse determination is sustained.


Federal Classification

• The Common Law Test
• The "Safe Harbor" of Section 530
• Recent Change in Approach
• Leased Employees
• IRS Training Manual

State Classification

State and Federal Overlap

• Worker Classification May Not Be Uniform

Avoiding The Issue Through Advance Planning

Resisting or Minimizing Adverse Determinations

• Resolution Strategies
• Minimizing Liabilities
• The "Math Credit" Argument
• Interest Relief