Determining whether an individual has been properly classified as an employee or an independent contractor is a perennial problem in the ground transportation industry. Many companies simply designate their chauffeurs as independent contractors, believing that so long as they do not deduct taxes from the chauffeur’s earnings and issue a 1099 at the end of the year, they are insulated from the liabilities that typically go hand-in-hand with an employment relationship. The use of independent contractors permits companies to avoid paying federal and state tax withholding, unemployment and disability insurance premiums, and the company’s share of Social Security and Medicare taxes (FICA).
Failing to properly classify workers costs the government billions of dollars each year in the form of unpaid taxes, and business expenses deducted by individuals who are not true independent contractors. The government’s response to this problem has been increased enforcement and auditing.
These audits can have costly consequences for unwary companies who fail to do their homework before designating workers as independent contractors. Fines, penalties and interest under the Internal Revenue Code can be quite substantial, particularly if the failure to properly classify a worker is deemed intentional.
If the company does not have the funds to pay, the IRS may seek to hold its officers, partners, accountant and/or bookkeeper personally liable. To make matters worse, the IRS will typically notify the state taxing authorities when violations are found, causing the state authority to conduct its own audit. The company can then expect to be hit with other assessments for unpaid unemployment insurance taxes, state/city/county withholding taxes, penalties and interest.
Unfortunately, and despite the high stakes involved, there is no uniform standard for determining whether a chauffeur is an independent contractor or an employee. There is, however, a set of guidelines issued by the IRS which can help you determine whether your drivers have been properly classified under IRS rules.
Historically, when the IRS evaluated whether a person was an employee in this industry, it applied what is commonly known as the 20-point common law test. Application of this generic multi-factor test to the limousine, or executive sedan industry, however, often leads to an inconsistent or inaccurate determination.
After extensive negotiations, in 1997 the IRS established audit guidelines specifically tailored to the limousine industry. These guidelines assist IRS agents in determining whether a company’s chauffeurs are employees or independent contractors.
Under the guidelines, in order for a driver to be properly considered an independent contractor, he must satisfy two “Critical Factors” and at least one of three “Significant Factors.”
If the presence of the two Critical Factors is established, the IRS will then look to see if one or more Significant Factors is present.
Two Critical Factors combined with one Significant Factor will usually, but not always, lead to a finding that the individual is an independent contractor. But while the IRS usually follows the findings of the aforementioned test, it is not required to do so.
Are the Two Critical Factors Met?
The two Critical Factors are a categorized as a significant investment, and risk of profit and loss.
* Significant Investment: According to IRS guidelines, the investment by a person in equipment and the incurring of expenses (such as for-hire vehicle insurance and licensing fees) used to perform services for another are considered to be factors which tend to establish an independent contractor relationship.
Typically, where the driver has title, physical possession and equity in his vehicle, he is found to have made a significant investment in the vehicle and is usually held to be an independent contractor.
The purchase or lease of a vehicle must be bona fide in order for it to be considered a significant investment. For example, the financing arrangements, be it for a purchase or lease, must create a true financial obligation on the part of the driver, as well as include a market rate of interest and customary security provisions.
A financial arrangement which ceases when the driver ends his affiliation with the company, or one which restricts the driver’s use of the vehicle only to the given company’s business, is not considered bona fide and does not constitute a “significant investment” under the guidelines.
* Risk of Profit and Loss: An employee is typically paid for his services on a time basis and as such has no opportunity for profit or loss. In comparison, according to the guidelines, the profitability of an independent contractor’s business generally depends upon variables he controls. Examples of variables which the driver controls and which impinge upon the profitability of an independent contractor’s business include insurance, maintenance, repairs, fuel, uniforms and other incidentals.
If the driver is found to have a significant investment in his business and to run the risk of profit and loss, he will typically be regarded as an independent contractor if he meets at least one of the three Significant Factors discussed below.
Is One “Significant Factor” Met?
The Significant Factors look to which party – the driver or the company -- has the right to control the driver. These three factors are whether the driver must personally perform the work, whether he can service the general or his own clients, and whether the instructions under which he operates leave him discretion.
* Who Performs Work: Drivers who must perform the work themselves are usually employees; drivers who can hire qualified assistants or subcontract with qualified third parties are usually independent contractors.
* Discretion to Serve the Public: Drivers restricted to servicing only your clients are usually employees; drivers who can have private clients are usually independent contractors.
* Instructions: The manner in which you instruct your drivers can make or break independent contractor status. The IRS guidelines note that when the company issues instructions as to how the driver must perform services, the driver is usually deemed an employee. Where the instructions are merely what should be done, independent contractor status is usually not compromised.
Independent Contractor Instructions
There are several instructions that the IRS deems are consistent with independent contractor status:
* Where and when to pick up passengers, and where to drop them off.
* Reasonable parameters for age, color, and capacity of vehicles and requirement that vehicle be clean, safe, and upscale.
* A requirement that the company logo be displayed in or on the vehicle and that the driver wear a suit, white shirt, and tie.
* Requirements regarding communications protocols.
* Requirements regarding processing of charge slips and accounting to the company for passenger revenues that are to be divided between the driver and the company.
* Dispatching protocols, such as allocation of jobs by geographic location of vehicle and availability of driver, or other neutral standards.
Likewise, there are several instructions that the IRS deems are inconsistent with independent contractor status:
* Requirements prescribing routes of travel (except as required by customers) and specific holding areas where limousine drivers wait (except as required by third parties, such as municipalities and airport authorities).
* Requirements fixing work hours, prescribing a minimum number of work hours, daily or weekly number of jobs, or otherwise fixing the driver’s work schedule.
* A requirement that drivers accept all jobs offered to them by the limousine company.
* A requirement that drivers refrain from using the vehicle for personal reasons.
* A requirement that drivers use certain suppliers for insurance, fuel, or repairs.
* A requirement that drivers perform all services personally and not substitute other drivers.
* A requirement that drivers stock their cars with specific food and drink items, reading materials, umbrellas, etc.
* Requirements regarding how the drivers should greet passengers and load passengers and luggage.
It is important to keep in mind that merely labeling a chauffeur as an independent contractor does not make him one in the eyes of the IRS. Likewise, simply identifying a driver’s status in a employee contract as an “independent contractor” does not make him one in the eyes of the IRS.
Courts look straight past such labels and examine whether the facts and circumstances indicate an employment relationship or an independent contractor relationship. Accordingly, limousine companies which wish to use independent contractors to perform their work should attempt to adhere to the IRS Guidelines as closely as possible.
Roberta Pike is a partner with Pike & Pike in Bellmore, N.Y. (www.pikeandpike.com). The firm specializes in commercial litigation, including workers compensation and unemployment insurance matters, employment practices, franchising and business practice matters.