Classification as a statutory employee.

• Author: Zimmerman, John C.

Most workers are classified as either an employee of someone else or self-employed. Each status has its advantages and disadvantages. Self-employed individuals have the advantage of being able to deduct their expenses on a Form 1040, Schedule C, Profit or Loss from Business, as direct offsets to income. However, they must pay the self-employment tax, which comprises the employer and employee share of FICA tax. (1) Employees pay only one-half of the Social Security and Medicare taxes, while the employer pays the other half. However, employees do not have the advantage of being able to deduct their expenses directly against income. Rather, employee business expenses are itemized deductions that are subject to the 2% of adjusted gross income limitation. For practical purposes, this means that many employees are not able to realize any tax deduction for their unreimbursed business expenses.

However, one category of workers--statutory employees--can enjoy the best of both worlds. They are like independent contractors but without substantial investment in the facilities used in the performance of services. The determination of who qualifies as a statutory employee turns on the facts of the situation.

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Statutory employees take direct deductions for their trade or business expenses against income on Schedule C, the same as self-employed individuals. However, they pay only one-half of their Social Security and Medicare taxes, with the employer paying the other half, just as if they were employees. Income tax is not withheld from statutory employees' wages. Although not considered to be self-employed, statutory employees still complete a Form 1040, Schedule C. They receive a Form W-2 that will have box 13, Statutory Employee, checked. Rev. Rul. 90-93 emphasizes that statutory employees are not employees for purposes of Sees. 62 (computation of adjusted gross income) and 67 (2% floor on miscellaneous itemized deductions). (2) For purposes of the federal unemployment tax (FUTA), only the first and last categories of statutory employees listed below are subject to it. The second and third categories are not subject to FUTA.(3)

Why Statutory Employees?

Unfortunately, there are no statistics detailing the number of taxpayers who file as statutory employees. The early legislative history ties the classification to a congressional desire that all employees be covered by Social Security. The Senate Finance Committee reported in 1950 that

the usual common-law rules for determining the employer-employee relationship fall short of covering certain individuals who should be taxed at the employee rate under the old-age and survivors insurance program. The statutory provisions set forth in paragraph (3) [now Sec. 3121(d)(3)] are designed to extend the definition [of employee J to include those individuals who, although not employees under the usual common-law rules, occupy substantially the same status as those who are employees under such rules. (4) The House of Representatives report further explained that the statutory employee provisions relate to "well-known occupational areas from which much of the present uncertainty and past litigation on this question has evolved" and that the groups were included as statutory employees "to assure the application of the [Social Security] employee tax rate to individuals who work in these occupations." (5)

Who Is a Statutory Employee?

The term "statutory employee" is not used in the Internal Revenue Code. However, Sec. 3121 (d)(3) defines the type of employee who is eligible to take advantage of these provisions. The individual must be classified as an employee who performs services for remuneration and is:

* An agent-driver or commission-driver who distributes meat products, vegetable products, fruit products, bakery products, or beverages (other than milk), or who picks up or delivers laundry or dry-cleaning for his or her principal.

* A full-time insurance salesperson.

* A home worker who performs work according to specifications of the person for whom the services are being performed, on materials or goods furnished by the person. The work product must be returned to the person or someone designated by him or her. * A traveling or city salesperson, other than an agent-driver or commission-driver (covered in the first point above), engaged on a full-time basis in the solicitation on behalf of a principal of orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or similar establishments for merchandise for resale or supplies for use in their business. However, the full-time basis rule will not be violated if the salesperson also performs some sideline activities for a person other than the principal.

The service contract between the employer and the statutory employee must provide that substantially all the services performed by the above classifications of employees must be performed personally by the individual. However, the rules for a statutory employee will not apply to an individual who has a substantial investment in the facilities used in the performance of the services (other than transportation facilities). Therefore, the individual will be allowed to own a personal auto for transport in the performance of the services. The rules will also not apply if the services are in the nature of a single transaction that is not part of a continuing relationship. A substantial investment in facilities indicates the worker is an independent contractor.(6)

A General Counsel Memorandum (7) explains the limitations on the requirement that the individual not have a substantial investment in the facilities. It ruled that the purchase of the exclusive rights to distribute and sell baked goods does not constitute a purchase of "facilities" under Sec. 3121(d)(3). The memo states that "the legislative history for section 3121(d) (3) ... indicates an intent to provide relief to a described group of individuals and a further intent that the exception based on investment in facilities not be interpreted broadly so as to undercut the intended relief." It cited from the original legislative history that "the facilities here pertinent include equipment and premises available for the work or enterprise as distinguished from education, training, and experience, but do not include such tools, instruments, equipment, or clothing as are commonly or frequently provided by employees."

Regs. Sec. 31.3121(d)-1 (d)(3) explains in greater detail the application of the section to the four categories.

Agent or commission driver: An agent-driver or commission-driver includes an individual:

* Who operates his or her own truck or the truck of the person for whom services are performed;

* Who serves customers designated by his or her principal as well as those he or she solicits; and

* Whose compensation is based on either a commission or the difference between the amount he or she charges the customer and the amount he or she pays to the principal for...