Taxation of Virtual Workers
Summer 2014
Developed by William E. Rogers, MBA, CFP, EA
Presented by XXXX
Table of Contents
Course Objectives ........................................................................................................................... 1
Introduction ..................................................................................................................................... 2
Types of Virtual Workers ............................................................................................................... 3
Telecommuters ............................................................................................................................ 3
IRS 20 Factor Test ...................................................................................................................... 4
Telecommuters as Common Law Employees............................................................................. 6
Workers Hiding Behind a Corporation: Independent Contractor or Disguised Employee? ....... 7
Outsourcing Providers ................................................................................................................ 8
Out of State & Overseas Worker Issues ......................................................................................... 9
Telecommuting Taxes ................................................................................................................. 9
State Registration & Filing Issues............................................................................................... 9
Overseas Workers ..................................................................................................................... 10
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Course Objectives






To be able to define and identify the types of virtual workers
To understand how to properly classify different types of virtual workers for tax purposes
To understand payroll reporting requirements for virtual workers
To discuss the efficacy of workers hiding behind corporations but acting as common law
employees
To understand other state tax and compliance issues related with hiring out of state
workers
To understand international tax issues related with hiring overseas workers
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Introduction
The United States has always been a very mobile society. Throughout much of our history,
Americans have been amenable to the idea of relocating from one part of the country to another,
for a chance to live a better life. It is noteworthy to point out that no other nation on Earth is like
the United States. A developed, prosperous nation built by a mobile population. Prior to the
advent of information technologies, determining the jurisdiction of where a worker was taxed
was relatively easy.
Up until the recent past, a worker performed most of his or her work in an office. That brick and
mortar office was customarily on the premises of the employer. Unfortunately, that time has
long past. Today in the 21st century, in large part due to the rapid proliferation of
communication technology, the workplace has been transformed. Gone are the days where
everyone works in the same office with one’s coworkers, gossiping at the water cooler, and
shuffling paper for most of the day. Email, fax machines, video conferencing, and the Internet
have knocked down the walls of office cubicles and opened up the floodgates for telecommuters.
Although technology in the 21st century has been instrumental in transforming the way that we
work and live, our taxation system has been slow in keeping up with the Digital Age. Thus, the
purpose of this course is to help serve as a primer for tax practitioners in learning how to
navigate the maze of payroll reporting issues that one may encounter when dealing with virtual
workers.
In this course, we will use the term “virtual worker” and “mobile worker” interchangeably. But,
before we begin we must clarify that whenever we refer to a virtual or mobile worker, we are
talking about someone who is performing a significant percentage of his or her duties away from
the employer’s premises. Conversely, we are not talking about salespeople or other categories of
employees such as business executives, who regularly travel for business. And finally, in this
course we are going to describe in depth three types of virtual workers, and how to go about
classifying them for tax purposes:
1.
Telecommuters
2.
Service providers
3.
Outsourcing Providers
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Types of Virtual Workers
Telecommuters
What are telecommuters? Telecommuters are considered to be workers who perform a portion of
their duties from home. Telecommuters can cover a broad spectrum of individuals who work
from home on occasion, may be once or twice a week, to those who work from home on a fulltime basis. Decades ago, telecommuting was not a problem from a tax practitioner’s perspective,
because most telecommuters were actually living in the same locality as their employer. For
example, ACME Tire Company headquartered in Phoenix, Arizona permits Sally Robinson, to
telecommute from her home in Tempe, Arizona. Tempe is in the same metropolitan area as
Phoenix. Consequently, Sally’s wages are reported to her on Form W-2 and ACME Tire
Company pays State Unemployment Insurance on her behalf, to the State of Arizona. Again,
this was a fairly straightforward scenario from a practitioner’s perspective.
However, when personal computers and Internet usage began to emerge in the late 1990s,
telecommuting was no longer constrained by geographical boundaries. High speed Internet and
Virtual Private Networks (VPNs) quickly became commonplace, thereby enabling workers to
perform their duties easily from another state or country.
What happens when Sally’s husband, Frank, all of a sudden is offered a job to work as an
Engineer for Ford Motor Company, and the entire family relocates to Dearborn, Michigan? In
the past, one spouse would’ve been forced to resign in order to accommodate the other spouse
accepting a job in another city. Sally loves her job and her employer, ACME Tire Co. would
like to keep her because she has proven herself to be an extremely loyal, hardworking employee
for the past five years. Because Sally has proven that she is capable of working from home,
ACME offers her the opportunity to telecommute on a full-time basis from her residence in
Michigan. ACME Tire Co. is a small business and they conduct their entire operations in
Phoenix, Arizona.
Question:
If ACME is your client, how would you advise them to report Sally’s wages while
telecommuting from Michigan?
Your options in regards to reporting her wages are one of the following:
●
Form 1099 MISC, Box 7 Nonemployee Compensation
●
Form W-2, State Wages and UI to Michigan
●
Form W-2, State Wages and UI to Arizona
ACME may naturally be inclined to opt to report her wages on a 1099, because they do not wish
to hassle with managing payroll for of an out of state worker. Unfortunately, doing what is easy
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does not necessarily mean doing what is correct. Alternatively, ACME may opt to continue
reporting her earnings on a W-2 to the State of Arizona; thinking that they are doing no wrong.
You as a tax practitioner must examine the facts and circumstances of each situation, in order to
render proper judgment in regards to properly classifying a worker for tax purposes.
Facts:
Sally Robinson, age 42 married filing joint with two children
Occupation: Customer Service Representative
Salary: $31,000 per year
Benefits: Company paid health insurance, 401k, and 2 weeks paid vacation per year
Duties: Answer customer service inquiries via telephone from company’s 800 number
The fact that Sally is working from home in Michigan doesn’t
change the nature of her job. Her job duties while living and
working in Michigan are the exact same as when she was living
and working in Arizona. Whether or not your client is Sally or
ACME, the company is naturally going to argue vigorously that
“Sally is free to work as she pleases, on her own schedule with
no supervision,” as depicted in the cartoon.
As a matter of fact, these arguments are quite common in
worker status examinations. Despite that, more often than not, they result unsuccessfully for the
taxpayer. That’s because the IRS and a majority of state agencies, base their ultimate
determination of a worker’s status on the standards set forth by years of established “common
law.” The common law standard is what the IRS uses to make its determination of a worker’s
status. The common law standard is based upon years of precedent set forth by employment tax
regulations and court decisions.
IRS 20 Factor Test
Revenue Ruling 87-41 establishes a 20 factor test that the IRS uses as a framework in
adjudicating a worker’s status. The 20 factors are:
1. Is the worker required to follow company instructions as to when, where, and how he
or she is to work?
2.
Does the company provide training?
3.
Are the worker’s services closely integrated with the business?
4.
Does the worker have to personally render the services, or can the worker subcontract
out the work?
5.
Does the company hire, supervise, and pay assistants to the worker?
6.
Is there a continuing relationship between the company and the worker where work is
performed at frequently recurring intervals?
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7.
Does the company set the work hours?
8.
Must the worker devote substantially full time to the company?
9.
Does the worker perform services on the company's premises?
10.
Must the worker perform services in the order or sequence set by the company?
11.
Must the worker submit oral or written reports to the company?
12.
Is the worker paid by the hour, week, or month?
13.
Does the company pay the business or traveling expenses of the worker?
14.
Does the company furnish significant tools, materials and equipment?
15.
Does the company have the right to fire the worker?
16.
Can the worker quit without incurring a liability to the company?
17.
Does the worker have a significant investment in tools or facilities?
18.
Can the worker realize a profit or loss as a result of his or her services?
19.
Does the worker provide substantial services to multiple companies at one time?
20.
Does the worker regularly advertise or make his or her services available to the
general public?
Bear in mind, that the IRS 20 Factor Test is not a simple yes / no questionnaire, meaning that if
one simply answers no in 11 out of 20 questions, then the worker is automatically deemed to be
an independent contractor. No quite the contrary. The IRS and several states have been adamant
in conveying publicly, that they do not base their decisions by merely adding up the number of
yes responses. Instead, the determination of a worker’s status is more subjective.
The IRS 20 Factor Test focuses on three interrelated issues to test the degree of control and
independence exhibited between the company and worker:
1.
Behavioral Control – Does the company control or have the right to control what the
worker does and how the worker does his or her job?
2.
Financial Responsibility – Does the company have the right to control the financial
aspects of how the job is performed? (these may things include things like how the
worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3.
Type of Relationship – Are there any written contracts or existence of employee
benefits? Also, will the relationship continue and is performed a key function of the
business?
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Telecommuters as Common Law Employees
Those individuals who tend to telecommute on a full-time basis are those that one would
consider to be rank and file employees. Full-time telecommuters typically perform some routine
administrative, customer service, sales, accounting, or human resource function on behalf of their
employers. The fact that these duties are performed from home doesn’t necessarily change the
nature of the relationship between the company and the worker. In fact, these duties are the
same in substance as their counterparts who work in a traditional office setting. Moreover, fulltime telecommuters tend not to be managerial workers, even though there are large percentages
of managers whom telecommute on a regular basis. They tend to be lower level positions that
must report to a direct supervisor, and do not possess any sort of specialized skills or
professional licensing, similar to attorneys, architects, engineers, or physicians.
Practitioner Tip:
Because no single factor is absolutely determinative of a worker’s status, the key is to be
able to effectively convey on behalf of your client, who (the employer or the worker) has
the right to control or direct the work? Complete IRS Form SS-8 if you wish to obtain a
determination of a worker’s status from the IRS.
Service Providers
In the previous section, we defined telecommuters as workers who regularly work from home for
the same employer. A service provider on the other hand, attempts to work with more than one
employer at a time. Service providers are actually synonymous with “freelance” workers or
“independent contractors.” The key difference between a telecommuter and a service provider is
that a service provider attempts to offer his or her services to as many customers as possible.
Hence, one might logically conclude that a service provider must be an independent contractor.
Right? That is not completely true. Again, because employers perceive payroll as a costly
burden, they’re going to be inclined to classify workers as independent contractors whenever
possible.
Warning!
You as a tax practitioner must be able to counsel your clients in being able to
distinguish the difference between an “independent contractor” and a disguised
employee.
In fact, employers are often mistaken in what truly distinguishes an independent service provider
from a “common law” employee who works virtually. Construction workers, salespeople, and
consultants are only a handful of occupations that have been prone to rampant abuse by
employers. Keep in mind that proper worker classification is not only a tax issue. There are also
related insurance, benefits, and workers’ rights issues that are of equal, if not greater
consequence to the employer. For example, in California a construction worker is not truly
considered to be an independent contractor unless he has a State Contractor’s License. It is
common for construction companies to hire subcontract workers for a particular job. When the
job is finished, the subcontractors are subsequently laid off. In fact, construction workers are
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accustomed to working for several employers over the course of a year. Furthermore, what
complicates this scenario even further is that technically speaking, a subcontractor can
conceivably be deemed an independent contractor for federal purposes, but a W-2 employee for
states purposes.
Practitioner Tip:
If you encounter a situation in which a worker is an independent contractor for federal
purposes but a W-2 employee for states purposes, then you must comply with the
appropriate payroll reporting requirement mandated by that worker’s state, i.e. making
unemployment insurance contributions, withholding state income taxes, and filing
quarterly wage reports.
Salespeople are another group of workers that are frequently misclassified by employers as
independent contractors. Employers often assert that because salespeople are remunerated on a
commission basis with no guarantees, they should be independent contractors. Again, this
argument fails over and over because there are scores of case law classifying salespeople as
common law employees. Consultants on the other hand, have a bit more latitude in being treated
as independent contractors. Still, you must use caution because employers may run the
temptation to classify everyone, including receptionists, as consultants.
In my opinion, in order for a worker to be considered a consultant, they must be in the business
of consulting, plain and simple. Likewise, the consultant should:
1.
Possess a specialized skill that is not routinely performed by the client company
2.
Provide a resource to the company that it cannot easily obtain on its own
3.
Dictate how, when, and what (tools, software, supplies, etc.) is used in the course of
the consulting engagement
4.
Be engaged in the business of offering his or her services to more than one client
Practitioner Tip:
The above guidelines are meant to provide insight into whether or not a worker passes a
basic “smell test” of conducting oneself as an independent businessperson.
Workers Hiding Behind a Corporation: Independent Contractor or
Disguised Employee?
Recently, a growing wave of companies under the advice of their legal counsel, have become
rather creative by requiring groups of W-2 employees (salespeople, consultants, engineers, etc.)
to form their own corporations or LLCs. The purpose of this strategy is for the worker to
contract back his services to the employer, but as a 1099 independent contractor. Again, you are
urged to use caution when utilizing such elaborate arrangements. Not only is employment law
extremely technical, but it is state specific. An employer should not engage in such a strategy
without proper legal counsel in the state(s) of the affected workers. Moreover, you must take
into consideration that this strategy is untested. For example, there are currently more than sixty
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class action lawsuits pending a higher court decision against FedEx, alleging that its Ground
drivers were improperly classified as independent contractors by the company. Nevertheless,
with bloated federal and state budget deficits, it is conceivable that tax examiners will
aggressively target these contractual arrangements, taking the position that they’re merely sham
transactions that lack economic substance.
A service provider in the truest sense is an independent contractor because they operate and
maintain their own business by offering their services to the general public. For example, an
Enrolled Agent, attorney, doctor, and plumber are examples of service providers who can
legitimately claim independent contractor status, if they are in the business of offering their
services to the public. On the other hand, an EA working for another EA, attorneys working for
a law firm, physicians working for a medical practice, and plumbers working for a plumbing
contractor, are all employees.
Practitioner Tip:
You will need to apply the IRS 20 factor test to determine for yourself at what point, the
worker crosses that magic threshold from being independent contractor to a common law
employee.
Outsourcing Providers
Over the past two decades, there has been a growing trend amongst businesses to outsource.
Today, it is quite common for companies to outsource almost everything imaginable, i.e. payroll,
staffing, manufacturing, R&D, etc. The key distinguishing characteristic between a service
provider and an outsourcing provider is scale. Outsourcing is usually performed by companies,
(ADP, UPS, Amazon.com, etc.); whereas, a service provider includes one person businesses.
Given the fact that companies engaged in the business of outsourcing are taking over entire
processes on behalf of their clients; they must possess the staffing and resources in order to
handle the volume of work. Many of you are already engaged in some form or another in
outsourcing. The key is that outsourcing providers are almost always businesses, and exhibit the
existence of an operation (facilities, personnel, IT, etc.). Thus, payments remitted to an
outsourcing provider would be reported on Form 1099 MISC, Box 7 Nonemployee
Compensation, unless the provider is a corporation. Finally, a growing phenomenon in the
outsourcing industry today is offshoring. Offshoring is outsourcing to another country. In the
next section, we will discuss reporting issues of out of state and overseas workers.
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Out of State & Overseas Worker Issues
Telecommuting Taxes
Up until now, much of our discussion was about federal taxation of virtual workers. Although
the IRS has jurisdiction nationally, states may take a competing view as to where a worker is
rightfully taxed. Lately, it has become increasingly complex determining where a worker is
taxed for state tax purposes. Currently, there are a handful of states, most notably New York, that
apply a little known doctrine called the "convenience of the employer" rule. This rule states that
when an employee works for a company located in a different state and chooses to telecommute
some of the time, the employer's state may tax the employee on 100% of his wages.
Notwithstanding, this includes not only the wages the telecommuter earns when he travels to the
employer's office, but also the wages he earns in his state of residence. Consequently, because
the state where the telecommuter lives taxes its residents on the income they earn at home,
telecommuters risk double taxation on their income. Legislation to remedy this potential double
tax calamity was introduced in Congress, the Telecommuter Tax Fairness Act of 2009 H.R 2600.
Unfortunately, as of the date of the writing of this publication, it has failed to reach the floor of
the U.S. House of Representatives for a vote.
State Registration & Filing Issues
The “convenience of the employer rule” is normally invoked when an employee works back and
forth, between their home and the employer’s offices. The “convenience of the employer” rule is
typically levied by the employer’s state of residence.
Nonetheless, if a virtual worker works from home on a regular full-time basis, then the employer
should actually be withholding state income taxes and paying unemployment contributions to
that worker’s state of residence. This means that the employer will first need to register to do
business in the worker’s home state.
Practitioner Tip:
To register to do business in a state, you need to register the company with the Secretary
of State Office of that state and pay the applicable filing fees.
Warning!
Once a company has a worker in another state, then the company has now established
a physical nexus to that state. Thus, the company has now become subject to all
applicable state and local taxes (income, payroll, property, sales and use tax).
Despite that, if an employer continues to report the worker’s wages to the employer’s state as
opposed to the worker’s home state, the worker’s state could challenge the employer’s position
by assessing applicable back taxes and penalties. Keep in mind that not only are labor laws
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different in each state, states lose revenue whenever a taxpayer claims a credit on his income tax
return for taxes paid to other states. Given the fact that many states are faced with huge budget
deficits, it is inevitable that they will battle for their share of a worker’s income.
Overseas Workers
With the increasing globalization of our economy, it is important to learn how to deal with
workers who are based overseas. In this final section we will discuss two types of overseas
virtual workers: expatriates and foreign nationals. Expatriates are U.S. citizens who live and
work in a foreign country. U.S. companies frequently send employees and managers overseas to
work on assignment for one of their foreign subsidiaries. The Expatriate worker will
telecommute back to the U.S. based corporate office, from their foreign work site. While the
worker is living and working overseas, their wages are still reported on Form W-2. If the worker
is abroad for 330 or more consecutive days, then the worker may exclude up to $92,900 of
foreign earned income in 2011.
Author’s Note:
Please note that the definition of an Expatriate worker is not to be confused with
Expatriate status used by the IRS. Companies that send workers overseas to work on
assignment are referred to as Expatriates or “Expats.” When the IRS refers to someone
who is an Expatriate, they are referring to an individual who has officially renounced
their U.S. citizenship. Thus, in this text when we refer to an Expatriate, we are referring
to someone who is on assignment for a U.S. company and has no intention of revoking
their citizenship.
A foreign national on the other hand, is considered to be a non-resident alien for U.S. tax
purposes. A foreign national worker’s income is subject to U.S. backup withholding only when
his income is effectively connected to the United States. In order for the worker’s income to be
Effectively Connected Income (ECI), the worker has to be present in the United States while
performing the work. The rapid proliferation of outsourcing websites such as Elance.com,
Odesk.com, and Freelance.com has made it easy for companies to hire virtual workers globally.
Because these foreign national virtual workers are not present in the United States, the source of
their income is deemed to be the country where the services are performed. Therefore, these
workers payments are not reportable on Form 1099 or Form 1042 and not subject to U.S.
withholding. See IRS Publications 515 Withholding of Tax on Nonresident Aliens and
Foreign Entities and 519 U.S. Tax Guide for Aliens, for additional information on U.S. tax
obligations pertaining to non resident aliens.
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William E. Rogers, MBA, CFP, EA is the founder of Ascend Business Advisory, a boutique
tax and financial advisory firm in San Diego, California. He holds a BS in Business Management
from the University of Redlands, an MBA from the University of Southern California, and an
MS in Finance from Golden Gate University. His practice specializes in the needs of
entrepreneurial start-up companies.
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NAEA created this educational program as part of its firm commitment to providing up-to-date,
convenient continuing education that focuses on the issues that members identify as top
priorities. Members are invited to suggest further areas of study or to submit presentations by
contacting hjones@naea.org. .
National Association of Enrolled Agents
1730 Rhode Island Ave, NW Ste 400
Washington, DC 20036
www.naea.org
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