Worker classification of health care professionals.

• Author: Nott, Sheri E.

The proper classification of a worker as an independent contractor or employee is an important tax issue facing the health care industry today. During the past five years, the Internal Revenue Service has initiated more than 43 Coordinated Examination Program (CEP) audits of health care entities involving hundreds of hospitals.(1) Several of these audits closed by 1996, resulting in an average assessment of $1 million and an average time for issue resolution of three years. The assessments were attributable in part to taxes due for reclassification of hospital personnel from independent contractors to employees.

The cost of misclassification of employees as independent contractors can be substantial. If workers are determined to be employees, several financial obligations arise under the Internal Revenue Code. For instance, the employer must withhold income taxes from wages, whether in cash or in kind, paid to an employee;(2) must withold Federal Insurance Contribution Act (FICA, commonly called Social Security) tax; and must pay a matching FICA tax equal to the employee portion of the tax.(3) Internal Revenue Code [sections] 3509, however, provides limited relief by reducing the amount of withholding and FICA tax upon meeting certain conditions. The employer must also pay any Federal Unemployment Tax Act (FUTA) tax.(4) The Service will assess interest and may, in addition, assess penalties in connection with the tax deficiencies arising from the misclassification. If a qualified-pension or profit-sharing plan was in effect, those plans may be disqualified. Moreover, the worker's status affects the application of other federal, state, and local laws. For example, classifying workers as independent contractors may allow the employer to avoid compliance with minimum wage laws, workers'compensation insurance, state unemployment taxes, collective bargaining laws, and compliance with the Americans with Disabilities Act.

This article examines the common law definition of "employee" as developed over the years and how factors comprising this definition apply to classifying physicians. These factors may be applicable to other health care professionals as well. This article also explains the relief provisions available to an employer under [sections] 530 of the Revenue Act of 1978,(5) including the changes made by the Small Business Job Protection Act of 1996,(6) and the Classification Settlement Program that may be offered by the Service. This article concludes with some suggestions as to how to minimize the risk of worker reclassification by the Service.

Background

The Service estimates that $2 billion in revenue is lost each year because over 3.4 million workers are misclassified as independent contractors.(7) The Service finds that independent contractors tend to understate their income and overstate their deductions, many of which would not be allowed if they were employees. Revenue is also lost because employers do not have to withhold employment taxes.

Despite any economic incentives to improperly classify workers as employees, the Service recognizes the difficulties and inconsistencies in applying the law to determine a worker's classification. Thus far, the Service's only solutions have been to promise better training of its personnel through publishing its training materials on "Worker Classifications For Tax Purposes As Independent Contractors Or Employees" (training materials) issued on March 4, 1997,(8) and to encourage settlement at the examination level by implementing the "Classification Settlement Program" for a two-year trial period beginning March 5, 1996.

Although repeatedly recognizing that worker classification is a major problem for businesses, Congress has failed to enact pending legislation that would greatly simplify the law.(9) Some speculate that the failure to enact legislation reflects the fear that such legislation would result in a reclassification of workers to independent contractor status, causing a lower compliance rate and further loss of revenue.

The health care industry is vulnerable to the Service's challenge of worker misclassification because health care entities have been the target of CEP audits and because the relationships with their workers have been changing rapidly. For example, newer health care delivery systems often lead to unusual models of integration. These relationships may be difficult for auditors who do not work on a daily basis in the health care industry to evaluate.

Definition of Employee

Federal tax laws require that a worker be classified as either an employee or independent contractor. Although workers in some occupations are classified by statute as employees or independent contractors,(10) most determinations are made by reference to the common law. The common law has evolved from the pre-colonial English law of master and servant, which generally looks to the degree of control exercised by the employer over the worker.(11) The common law test generally used by the courts is stated in Treas. Reg. [sections] 31.3401(c)-1(b):

[T]he relationship of employer and employee exists when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only to the result to be accomplished by the work but also to the details and means by which that result is accomplished.

The Service recognizes that the common law must be considered in determining worker classification. In Rev. Rul. 87-41, the Service published a list of 20 common law factors that had been identified by courts to be used as an aid in determining the existence or absence of the right to control the worker.(12) No single factor is controlling and not all factors apply to every occupation. Many criticize the 20-factor test as too subjective and broad, leading to inconsistent...