Employee to Independent Contractor

[JohnH]

Incorporated business employs the owner/sole shareholder as full time sales rep and another part-time sales rep. Sales rep works in the office 15 hours per week, plus occasional travel. He is paid an hourly rate for the 15 hrs, plus 10% commission on sales. Travel expenses are paid by the company under an accountable plan. The company also has a history of making a contribution to a SEP for both owner and employee of 10% of annual salary/wages (in good years).

The owner is scaling back the business and is considering downsizing the office. He intends to drop the hourly compensation and have the sales rep work from home. No set hours or other requirements for the sales rep, other than to follow up on sales leads when they arise and are forwarded to him. Sales rep is free to accept or reject sales leads at his discretion. (Travel too far, past experience with customer, etc) Owner intends to increase the sales rep's commission to 13%, plus continued reimbursement for travel expenses when they are incurred.

Owner is wanting to convert the sales rep from employee to Independent Contractor under this new arrangement. He reassons that the 30% increase in commission will cover the sales rep's additional self-employment tax and leave some extra to partiallly offset the decrease in hourly rate and some for the sales rep to make contributions to his own SEP if he wishes. Sales rep knows that total compensation will decrease due to elimination of the hourly pay, but he is fine with this as he is transitioning into retirement.

Any thoughts on the success of this plan? And any comments or suggestions on how to make it more bullet proof if ever questioned by IRS?

[TAXNJ]

Follow test

Think no problem if generally if following the IRS Independent Contractor Test which generally states:


Excerpt from IRS web-site:
"Common Law Rules
Facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?"

[spanel]

Incorporated business employs the owner/sole shareholder as full time sales rep and another part-time sales rep. Sales rep works in the office 15 hours per week, plus occasional travel. He is paid an hourly rate for the 15 hrs, plus 10% commission on sales. Travel expenses are paid by the company under an accountable plan. The company also has a history of making a contribution to a SEP for both owner and employee of 10% of annual salary/wages (in good years).

The owner is scaling back the business and is considering downsizing the office. He intends to drop the hourly compensation and have the sales rep work from home. No set hours or other requirements for the sales rep, other than to follow up on sales leads when they arise and are forwarded to him. Sales rep is free to accept or reject sales leads at his discretion. (Travel too far, past experience with customer, etc) Owner intends to increase the sales rep's commission to 13%, plus continued reimbursement for travel expenses when they are incurred.

Owner is wanting to convert the sales rep from employee to Independent Contractor under this new arrangement. He reassons that the 30% increase in commission will cover the sales rep's additional self-employment tax and leave some extra to partiallly offset the decrease in hourly rate and some for the sales rep to make contributions to his own SEP if he wishes. Sales rep knows that total compensation will decrease due to elimination of the hourly pay, but he is fine with this as he is transitioning into retirement.

Any thoughts on the success of this plan? And any comments or suggestions on how to make it more bullet proof if ever questioned by IRS?

I think he needs to move away from commission and the sub has to bid out the jobs somehow... otherwise to me, he is still paying an employee based off sales, not based off what the sub it charging for a job. Also nix the reimbursement for travel as it would not be his responsibility anymore.... IE that needs to be taking into consideration to the sub when the job is bid.

Chris

[JohnH]

I think he needs to move away from commission and the sub has to bid out the jobs somehow... otherwise to me, he is still paying an employee based off sales, not based off what the sub it charging for a job. Also nix the reimbursement for travel as it would not be his responsibility anymore.... IE that needs to be taking into consideration to the sub when the job is bid.

Chris

Interesting. Thanks for both replies. I've been looking at the 20 common law factors and I'm leaning toward I/C status being OK, although admittedly it isn't a slam dunk. I'm not overly concerned about the commission arrangement, since it is common practice in the industry and is in fact exactly how the company is paid by the manufacturers it represents. Since that is a long-standing practice in the industry, it is pretty well established. Even the owner does not have the right to set prices - that is dictated by the manufacturer who simply remits a fixed percentage commission to the company when a sale takes place. As for the expenses, I/C's are often reimbursed for expenses over and above their compensation. For example, a dinner speaker is usually paid a fee for the speech plus travel & lodging as a separate line item. But I get your point.

One thought would be to have the I/C form an LLC and the company would pay the LLC. The I/C would then pay himself from the LLC. That adds a firewall on a couple of levels, at a cost of $200/year plus the cost to the sales rep of maintaining a checking account. The sales rep can then report the LLC income on Schedule C as a disregarded entity, so there's no extra tax return to prepare.

[Nashville]

Risk involved

A couple of comments...

The salesman would be well-advised to apply his talents to other companies and have more than one customer. Due to the nature of some selling arrangements this may not be possible unless he gets out of his product line.

I would increase the salesman's percentage, and make him responsible for his own travel. This adds an element of risk in that the salesman must evaluate the chances of winning a sale versus the cost of travel. Having the principal continue to pay for the travel still smacks of an employee relationship.

The more ordinary and necessary expenses the salesman can bear the responsibility, the better chances for treatment as an independent contractor. This adds another element to the discussion - the salesman must document his expenses or he won't be able to deduct them. If he can't substantiate ordinary and necessary business expenses on his tax return, this may work against him claiming treatment as an indenpendent contractor. I will have to add also that many salesman-personality types don't want to document these type expenses, based on my experience.

[TAXNJ]

Very

A couple of comments...

The salesman would be well-advised to apply his talents to other companies and have more than one customer. Due to the nature of some selling arrangements this may not be possible unless he gets out of his product line.

I would increase the salesman's percentage, and make him responsible for his own travel. This adds an element of risk in that the salesman must evaluate the chances of winning a sale versus the cost of travel. Having the principal continue to pay for the travel still smacks of an employee relationship.

The more ordinary and necessary expenses the salesman can bear the responsibility, the better chances for treatment as an independent contractor. This adds another element to the discussion - the salesman must document his expenses or he won't be able to deduct them. If he can't substantiate ordinary and necessary business expenses on his tax return, this may work against him claiming treatment as an indenpendent contractor. I will have to add also that many salesman-personality types don't want to document these type expenses, based on my experience.

Very important and good points supporting "Independence". Great reply Nashville

[JohnH]

Yes, I agree.
Very good analysis.

The rep isn't interested in taking on new lines, even though he would have the option to do so. As a matter of fact, he already has that right but chooses not to do it. He is transitioning into retirement and just wants to keep the income stream open by taking advantage of some unique knowledge & skills he possesses. He can earn $25k - $30k annually with a minimum of effort and he is content to keep it that way.

Increasing the percentage and making the sales rep responsible for his own expenses would add more ammunition to the I/C argument. Might even tilt it completely in an audit. There is good historical data to fairly estimate the expenses as a percentage of sales. And if actual expenses exceeded the added percentage, it might be possible to add a "bonus" percentage at year-end to make him whole; just as long as they don't classify it as expense reimbursement.

[Roland Slugg]

There shouldn't be any difficulties supporting the switch from EE to IC as long as the salesman stops coming into the office on a regular basis. I do, however, share Nashville's concern about the continuation of travel reimbursements. The concept of an "accountable" reimbursement plan is inconsistent with IC status. My suggestion regarding that is to look back and see how much the travel reimbursements actually paid to the salesman have been for the past year or two, as a percentage of his sales. Then eliminate the reimbursements and increase his commission percentage to roughly compensate.

It would be a good idea to get everything in writing in the form of a simple IC contract/agreement signed by both parties.

[kathyc2]

Unless salesperson files an SS-8, IMO highly doubtful that it will ever be questioned.

One thing not mentioned here is if salesperson presents himself as being an employee of the company as in items such as business card.

[JohnH]

Although it is probably better to stay away from an accountable plan in order to help establish the I/C Status, I do want to mention that the notion that an accountable plan nixes the I/C status is not accurate. As I said in an earlier post, there are many situations in which an I/C might be directly reimbursed for actual expenses under an accountable plan. For example, a conference speaker who lives in Chicago would likely be reimbursed a much larger amount to travel to Los Angeles vs a trip to Milwaukee. Their speaking fee might be the same, but their travel reimbursement would be much different.

Pub 463 clearly recognizes that Accountable Plan reimbursements to Independent contractors are acceptable.
(I would post a link, but I understand that is not allowable on this forum any longer).
I don't want to get in the doghouse, so here is a cut-and-paste from the pub.

This actually draws a clear distinction between an accountable and non-accountable plan for an I/C.
The rules are essentially the same for either an employee or an I/C.

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Rules for Independent Contractors and Clients


This section provides rules for independent contractors who incur expenses on behalf of a client or customer. The rules cover the reporting and substantiation of certain expenses discussed in this publication, and they affect both independent contractors and their clients or customers.

You are considered an independent contractor if you are self-employed and you perform services for a customer or client.


Accounting to Your Client


If you received a reimbursement or an allowance for travel, entertainment, or gift expenses that you incurred on behalf of a client, you should provide an adequate accounting of these expenses to your client. If you do not account to your client for these expenses, you must include any reimbursements or allowances in income. You must keep adequate records of these expenses whether or not you account to your client for these expenses.

If you do not separately account for and seek reimbursement for meals and entertainment in connection with providing services for a client, you are subject to the 50% limit on those expenses. See 50% Limit in chapter 2.

Adequate accounting. As a self-employed person, you adequately account by reporting your actual expenses. You should follow the recordkeeping rules in chapter 5 .

How to report. For information on how to report expenses on your tax return, see Self-employed at the beginning of this chapter.


Required Records for Clients or Customers


If you are a client or customer, you generally do not have to keep records to prove the reimbursements or allowances you give, in the course of your business, to an independent contractor for travel or gift expenses incurred on your behalf. However, you must keep records if:


•You reimburse the contractor for entertainment expenses incurred on your behalf, and


•The contractor adequately accounts to you for these expenses.


Contractor adequately accounts. If the contractor adequately accounts to you for entertainment expenses, you (the client or customer) must keep records documenting each element of the expense, as explained in chapter 5 . Use your records as proof for a deduction on your tax return. If entertainment expenses are accounted for separately, you are subject to the 50% limit on entertainment. If the contractor adequately accounts to you for reimbursed amounts, you do not have to report the amounts on an information return.

Contractor does not adequately account. If the contractor does not adequately account to you for allowances or reimbursements of entertainment expenses, you do not have to keep records of these items. You are not subject to the 50% limit on entertainment in this case. You can deduct the reimbursements or allowances as payment for services if they are ordinary and necessary business expenses. However, you must file Form 1099-MISC to report amounts paid to the independent contractor if the total of the reimbursements and any other fees is $600 or more during the calendar year.

[Burke]

I think the plan will pass muster as well. Have experience with real estate-related IC's, and they may only work for one company by contract. State real estate boards require them to be affiliated with a supervising broker-company firm. They have long been held to be IC's by the IRS, although the IRS doesn't like it. Insurance agents can be independent and be affiliated with different companies by license. Also, have one who submits an expense report for certain things like travel, lodging, etc and is reimbursed. These might be only certain occasions where the company requests his presence at its headquarters either for training sessions, seminar presentations, etc. Otherwise, he is responsible for his own travel expenses.