Tax Court Labels Project-Based Construction Workers as Employees

The IRS and construction firms are often at loggerheads over whether certain workers should be treated as employees or independent contractors. Typically, the IRS will contend that the workers are employees, while the construction firm will argue that the workers should be classified as independent contractors.

It’s not just semantics; there could be a bundle in tax dollars at stake.

The outcome depends on the particular facts and circumstances. In a new case, the Tax Court decided in favor of the IRS, even though the construction firm hired the workers on a project-by-project basis.

Background:  Employers and employees are subject to employment taxes under FICA (Social Security taxes), and employers are also subject to unemployment taxes under FUTA. Employers are required to withhold FICA tax and federal income tax on wage payments made to their employees, but these employment taxes don’t apply to payments to independent contractors.

Under the prevailing tax code section, an “employee” is defined as an individual who, under the common law, has the status of an employee. Whether an individual is a common law employee is a question of fact to be determined by applying these seven factors:

1.      The degree of control exercised by the principal.

2.      Which party invests in work facilities used by the individual.

3.      The opportunity of the individual retained to realize a profit or loss.

4.      Whether the principal can discharge the individual.

5.      Whether the work is part of the principal’s regular business.

6.      The permanency of the relationship.

7.      The relationship the parties believed they were creating.

However, under Section 530 of the Revenue Act of 1978 (as amended), a taxpayer that incorrectly treats an employee as an independent contractor is nevertheless exempt from employment tax liability if it meets these requirements:

  • The taxpayer does not treat any other individual holding a substantially similar position as an employee for purposes of employment taxes for any period.
  • The taxpayer has consistently treated the worker as not being an employee for post-1978 periods, including by filing all required federal tax returns on a basis consistent with this treatment.
  • The taxpayer has a reasonable basis for not treating the individual as an employee.

In 2005 (the tax year at issue), Mieczyslaw Kurek was the sole proprietor of KMA Construction, a home improvement company engaged in installing tile, sheetrock, doors, and windows, as well as painting and carpentry. Throughout the year, Kurek (through KMA) worked on approximately 20 to 30 residential projects in Brooklyn, NY.

Kurek hired workers throughout the year (28 were listed in the notice of determination). He supervised them, told them what work needed to be done, and set deadlines for all the jobs. All workers performed on a project-to-project basis, and they did not work under business names or advertise to the public. Kurek paid each worker every week, by personal check, according to the percentage of the work completed.

Kurek also managed the day-to-day operations of KMA Construction. He worked closely with the homeowner on each project, discussing the details of the work to be performed and the supplies needed, and negotiating the cost of the project taking into account the payments that he negotiated with the workers. The homeowners paid Kurek directly and spoke with him regarding any problems with the work.

The workers set their own hours and work schedules, provided their own transportation to the worksites, and used their own set of small tools, with Kurek supplying larger tools. Kurek did not tell the workers how to do their jobs, but he would replace workers if a deadline was approaching or if a worker was holding up a job. He would order workers to repair problems or redo work if he felt it was being done improperly. He did not provide training, offer employee benefits (such as sick pay or medical insurance), or carry unemployment insurance.

For 2005, Kurek did not issue Forms 1099-MISC (Miscellaneous Income) or Forms W-2 (Wage and Tax Statement) to any of the workers, and did not file Forms 941 (Employer’s Quarterly Federal Tax Return) or Form 940 (Employer’s Annual Federal Unemployment Tax Return). Nor did he pay any employment taxes or remit periodic deposits for the workers. In 2009, the IRS prepared substitutes for returns (SFRs) for Kurek’s Forms 941 for all quarters in 2005 and an SFR for his Form 940 for the year, based on its determination that the workers were employees in 2005.

The Tax Court analyzed each of the factors outlined above and concluded that the workers should have been treated as employees. Here’s why:

Kurek had control over the workers. The Court characterized the right of the principal to exercise control over the agent, regardless of whether the principal actually does so, as the “crucial test” in analyzing for an employer-employee relationship. In this instance, Kurek set the deadlines, monitored the work done, visited the worksites, instructed the workers on the work they were to do and had the right to approve its quality, paid them weekly, and was ultimately responsible for the success of the project. Overall, these facts heavily favored employee status.

Kurek supplied heavy tools and materials. The workers used their own small tools to perform most of their work, but Kurek supplied all heavy tools and purchased all materials used by the workers. This factor slightly favored employee status.

Workers could be discharged. Although the workers were hired on a project-to-project basis, Kurek could replace any workers that failed to meet a deadline or perform to Kurek’s satisfaction. This favored employee status.

Workers were integral to the business. Without the workers, Kurek wouldn’t have been able to finish 20-30 projects, while at the same time finding new projects and working with the homeowners. This favored employee status.

The work relationship was largely transitory. The workers were hired for one project at a time, they were free to work on other projects or with other groups, and only seven of the workers actually worked for Kurek during all four quarters of 2005. This slightly favored independent contractor status.

The parties believed they created independent contractor relationship. Kurek and one of the workers credibly testified that they believed they created an independent contractor relationship, which favored independent contractor status.

Overall, the Tax Court agreed with IRS that the workers were employees during 2005. The Court then considered the applicability of Section 530 relief, but ultimately found Kurek to be ineligible. All three requirements outlined above must be satisfied in order to qualify for relief, and Kurek didn’t satisfy the second prong (consistent treatment of worker as not being an employee) based on his failure to file Forms 1099-MISC as required by law (Kurek, TC Memo 2013-64).

Don’t make the same mistake as this construction firm owner. Do whatever you can to bolster the position that workers are independent contractors. At the very least, be consistent so you can meet the requirements for Section 530 relief. Contact your tax advisor for more information.