Factors Considered in Classification: Employee Versus Independent Contractor Status

Chapter 17 Digging Deeper

Contents:

FACTORS CONSIDERED IN CLASSIFICATION: EMPLOYEE VERSUS INDEPENDENT CONTRACTOR STATUS

1.Example:Frank is a licensed practical nurse who works as a private-duty nurse. He is under the supervision of the patient’s doctor and is paid by the patient. Frank is not an employee of either the patient (who pays him) or the doctor (who supervises him). The ways and means of attaining the end result (care of the patient) are under his control.

FACTORS CONSIDERED IN CLASSIFICATION: EMPLOYEE VERSUS INDEPENDENT CONTRACTOR STATUS

2. In addition to independent contractors, employees in a special category are allowed to file Schedule C and deduct expenses for AGI. These employees are called statutory employees because they are not common law employees under the rules explained above. The wages or commissions paid to statutory employees are not subject to Federal income tax withholding but are subject to Social Security tax.1

GROUP TERM LIFE INSURANCE

3. Generally, the amount that must be included in gross income, computed from Table 17–1 in the text, is much less than the price an individual would pay an insurance company for the same amount of protection. Thus, even the excess coverage provides some tax-favored income for employees when group term life insurance coverage in excess of $50,000 is desirable.

GENERAL CLASSES OF EXCLUDED BENEFITS

4. No-Additional-Cost Services. Note that if Vern were employed in a hotel owned by Trans National, the receipt of the airline ticket would be taxable because Vern did not work in that line of business. However, the Code allows the exclusion for reciprocal benefits offered by employers in the same line of business.

Example:Grace is employed as a desk clerk for Plush Hotels, Inc. The company and Chain Hotels, Inc., have an agreement that allows any of their employees to stay without charge in either company’s resort hotels during the off-season. Grace would not be required to recognize income from taking advantage of the plan by staying in a Chain Hotel.

GENERAL CLASSES OF EXCLUDED BENEFITS

5. Nondiscrimination Provisions. The de minimis benefits are not subject to tax because the accounting problems that would be created are out of proportion to the amount of additional tax that would result. A nondiscrimination test would simply add to the compliance problems. In the case of working condition fringes, the types of services required vary with the job. Therefore, a nondiscrimination test probably could not be satisfied, although usually there is no deliberate plan to benefit a chosen few.

TRANSPORTATION EXPENSES

6. Commuting Expenses. The rule that disallows a deduction for commuting expenses has several exceptions. An employee who uses an automobile to transport heavy tools to work and who otherwise would not drive to work is allowed a deduction, but only for the additional costs incurred to transport the work implements. Additional costs are those exceeding the cost of commuting by the same mode of transportation without the tools. For example, the rental of a trailer for transporting tools is deductible, but the expenses of operating the automobile generally are not deductible.2 The Supreme Court has held that a deduction is permitted only when the taxpayer can show that the automobile would not have been used without the necessity to transport tools or equipment.3

Another exception is provided for an employee who has a second job. The expenses of getting from one job to another are deductible. If the employee goes home between jobs, the deduction is based on the distance between jobs.

If the taxpayer is required to incur a transportation expense to travel between work stations, that expense is deductible.

Example: Thomas, a general contractor, drives from his home to his office, then drives to three building sites to perform his required inspections, and finally drives home. The costs of driving to his office and driving home from the last inspection site are nondeductible commuting expenses. The other transportation costs are deductible.

Likewise, the commuting costs from home to a temporary work station and from the temporary work station to home are deductible.4

Example:Vivian works for a firm in downtown Denver and commutes to work. She occasionally works in a customer’s office. One day, Vivian drove directly to the customer’s office, a round-trip distance from her home of 40 miles. She did not go into her office, which is a 52-mile round-trip. Her mileage for going to and from the customer’s office is deductible.

Also deductible are reasonable transportation costs between the general working area and a temporary work station outside that area.5 What constitutes the general working area depends on the facts and circumstances of each situation. Furthermore, if an employee customarily works on several temporary assignments in a localized area, that localized area becomes the regular place of employment. Transportation from home to these locations becomes a personal, nondeductible commuting expense.

Example:Sam, a building inspector in Minneapolis, regularly inspects buildings for building code violations for his employer, a general contractor. During one busy season, the St. Paul inspector became ill, and Sam was required to inspect several buildings in St. Paul. The expenses for transportation for the trips to St. Paul are deductible.

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TRANSPORTATION EXPENSES

7. Computation of Automobile Expenses. A basis adjustment is required if the taxpayer changes from the automatic mileage method to the actual operating cost method. Depreciation is considered allowed for the business miles in accordance with the following schedule for the most recent five years:

Year / Rate per Mile
2007 / 19 cents
2006 / 17 cents
2005 / 17 cents
2004 / 16 cents
2003 / 15 cents

Example:Tim purchased his automobile in 2004 for $36,000. Tim drove the automobile for 10,000 business miles in 2006; 8,500 business miles in 2005; and 6,000 business miles in 2004. The automobile is used for business 90% of the time. At the beginning of 2007, the basis of the business portion is $28,295.

Cost ($36,000 x 90%) / $32,400
Less depreciation:
2006 (10,000 miles x 17 cents) / (1,700)
2005 (8,500 miles x 17 cents) / (1,445)
2004 (6,000 miles x 16 cents) / (960)
Adjusted basis 1/1/2007 / $28,295

TRAVEL EXPENSES

8. Restrictions on Travel Expenses. The possibility always exists that taxpayers will attempt to treat vacation or pleasure travel as deductible business travel. To prevent such practices, the law contains restrictions on certain travel expenses.

For convention travel expenses to be deductible, the convention must be directly related to the taxpayer’s trade or business.6

Example:Dr. Hill, a pathologist who works for a hospital in Ohio, travels to Las Vegas to attend a two-day session on recent developments in estate planning. No deduction is allowed for Dr. Hill’s travel expenses.

Example:Assume the same facts as in the previous example, except that the convention deals entirely with recent developments in forensic medicine. Under these circumstances, a travel deduction is allowed.

If the proceedings of the convention are videotaped, the taxpayer must attend convention sessions to view the videotaped materials along with other participants. This requirement does not disallow deductions for costs (other than travel, meals, and entertainment) of renting or using videotaped materials related to business.

Example:A CPA is unable to attend a convention at which current developments in taxation are discussed. She pays $200 for videotapes of the lectures and views them at home later. The $200 is an itemized deduction if the CPA is an employee. If she is self-employed, the $200 is a deduction for AGI.

The Code places stringent restrictions on the deductibility of travel expenses of the taxpayer’s spouse or dependent.7 Generally, the accompaniment by the spouse or dependent must serve a bona fide business purpose, and the expenses must be otherwise deductible.

Example:Assume the same facts as in the example in which Dr. Hill attends a conference on recent developments on forensic medicine, with the additional fact that Dr. Hill is accompanied by Mrs. Hill. Mrs. Hill is not employed, but possesses secretarial skills and takes notes during the proceedings. No deduction is allowed for Mrs. Hill’s travel expenses.

Example:Assume that Mrs. Hill in the previous example is a nurse trained in pathology, who is employed by Dr. Hill as his assistant. Now, Mrs. Hill’s travel expenses qualify as deductions.

Travel as a form of education is not deductible.8 If, however, the education qualifies as a deduction, the travel involved is deductible.

Example:Greta, a German teacher, travels to Germany to maintain general familiarity with the language and culture. No travel expense deduction is deductible.

Example:Jean-Claude, a professor of French literature, travels to Paris to do specific library research that cannot be done elsewhere and to take courses that are offered only at the Sorbonne. The travel costs are deductible, assuming that the other requirements for deducting education expenses (discussed later in this chapter) are met.

TRAVEL EXPENSES

9. Combined Business and Pleasure Travel.

Example:Hana goes to New York for a two-week vacation. While there, she spends several hours renewing acquaintances with people in her company’s New York office. Her transportation expenses are not deductible.

TRAVEL EXPENSES

10. Conventions Located Outside North America. Certain restrictions are imposed on the deductibility of expenses paid or incurred to attend conventions located outside North America. The expenses are disallowed unless it is established that the meeting is directly related to a trade or business of the taxpayer. Disallowance also occurs unless the taxpayer shows that it is as reasonable for the meeting to be held in a foreign location as within the North American area.

MOVING EXPENSES

11. Time Test. A taxpayer might not be able to meet the 39-week test by the due date of the tax return for the year of the move. For this reason, two alternatives are allowed. The taxpayer can take the deduction in the year the expenses are incurred, even though the 39-week test has not been met. If the taxpayer later fails to meet the test, either (1) the income of the following year is increased by an amount equal to the deduction previously claimed for moving expenses, or (2) an amended return is filed for the year of the move. The second alternative is to wait until the test is met and then file an amended tax return for the year of the move.

MOVING EXPENSES

12. Treatment of Moving Expenses. Qualified moving expenses that are paid (or reimbursed) by the employer are not reported as part of the gross income of the employee.9 Moving expenses that are paid (or reimbursed) by the employer and are not qualified moving expenses are included in the employee’s gross income and are not deductible. The employer is responsible for allocating the reimbursement between the qualified and non-qualified moving expenses. Reimbursed qualified moving expenses are separately stated on Form W–2 given to the employee for the year involved. Qualified moving expenses that are not reimbursed and those of self-employed taxpayers are deductions for AGI.10

Form 3903 is used to report the details of the moving expense deduction if the employee is not reimbursed or if a self-employed person is involved.

EDUCATION EXPENSES

13. Requirements Imposed by Law or by the Employer for Retention of Employment. In contrast to Example 35 in the text, a taxpayer classified as an Accountant I who went back to school to obtain a bachelor’s degree was not allowed to deduct the expenses. Although some courses tended to maintain and improve his existing skills in his entry-level position, the degree was the minimum requirement for his job. See the exception treatment under A Limited Deduction Approach in the text.11

ENTERTAINMENT EXPENSES

14. The Fifty Percent Cutback. In certain situations a full 50 percent cutback seems unfair. If, for example, the hours of service are regulated (i.e., by the U.S. Department of Transportation) and away-from-home meals are frequent and necessary, the “three martini” business lunch type of abuse is unlikely. Consequently, the Taxpayer Relief Act of 1997 (TRA of 1997) eased the cutback rule for the following types of employees:

Certain air transportation employees, such as flight crews, dispatchers, mechanics, and control tower operators.
Interstate truck and bus drivers.
Certain railroad employees, such as train crews and dispatchers.
Certain merchant mariners.

Starting in 1998, the cutback is reduced by 5 percent at two-year intervals until it reaches 20 percent in year 2008 and thereafter. Thus, 80 percent of the cost of meals will eventually be allowed as a deduction. For 2006-2007, 75 percent is allowed, for 2004-2005, 70 percent is allowed; and for 2000-2001, 60 percent is allowed.

ENTERTAINMENT EXPENSES

15. The Fifty Percent Cutback. The cutback rule has a number of exceptions. One exception covers the case where the full value of the meals or entertainment is included in the compensation of the employee (or independent contractor).12

Example:Myrtle wins an all-expense-paid trip to Europe for selling the most insurance for her company during the year. Her employer treats this trip as additional compensation to Myrtle. The cutback adjustment does not apply to the employer.

A similar exception applies to meals and entertainment in a subsidized eating facility or where the de minimis fringe benefit rule is met.13

Example:Canary Corporation gives a turkey, a fruitcake, and a bottle of wine to each employee at year-end. Since the de minimis fringe benefit exclusion applies to business gifts of packaged foods and beverages, their full cost is deductible by Canary.

A similar exception applies to employer-paid recreational activities for employees (e.g., the annual golf outing or spring picnic).14

ENTERTAINMENT EXPENSES

16. Ticket Purchases for Entertainment. A deduction for the cost of a ticket for an entertainment activity is limited to the face value of the ticket.15 This limitation is applied before the 50 percent cutback. The face value of a ticket includes any tax. Under this rule, the excess payment to a scalper for a ticket is not deductible. Similarly, the fee to a ticket agency for the purchase of a ticket is not deductible.

If a luxury skybox is used for entertainment that is directly related to or associated with business, the deduction is limited to the face value of nonluxury box seats. All seats in the luxury skybox are counted, even when some seats are unoccupied.

The taxpayer may also deduct stated charges for food and beverages under the general rules for business entertainment. The 50 percent cutback rule applies to deductions for skybox seats, food, and beverages.

Example:In the current year, Pelican Company pays $6,000 to rent a 10-seat skybox at City Stadium for three football games. Nonluxury box seats at each event range in cost from $25 to $35 a seat. In September, a Pelican representative and five clients use the skybox for the first game. The entertainment follows a bona fide business discussion, and Pelican spends $86 for food and beverages during the game. The deduction for the first sports event is as follows:

Food and beverages / $ 86
Deduction for seats ($35 x 10 seats) / 350
Total entertainment expense / $436
50% limitation / x .50
Deduction / $218

OTHER EMPLOYEE EXPENSES

17. Office in the Home. The home office limitation cannot be circumvented by leasing part of one’s home to an employer, using it as a home office, and deducting the expenses as a rental expense under § 212. Form 8829 (Expenses for Business Use of Your Home) may be used for computation of the office in the home deduction.

CLASSIFICATION OF EMPLOYEE EXPENSES

18. Deemed Substantiation. In lieu of reimbursing actual expenses for travel away from home, many employers reduce their paperwork by adopting a policy of reimbursing employees with a per diem allowance, a flat dollar amount per day of business travel. Of the substantiation requirements listed above, the amount of the expense is proved, or deemed substantiated, by using such a per diem allowance or reimbursement procedure. The amount of expenses that is deemed substantiated is equal to the lesser of the per diem allowance or the amount of the Federal per diem rate.

The regular Federal per diem rate is the highest amount that the Federal government will pay to its employees for lodging and meals16 while in travel status away from home in a particular area. The rates are different for different locations.17

The use of the standard Federal per diem for meals constitutes an adequate accounting. Employees and self-employed persons can use the standard meal allowance instead of deducting the actual cost of daily meals, even if not reimbursed.

Only the amount of the expense is considered substantiated under the deemed substantiated method. The other substantiation requirements must be provided: place, date, business purpose of the expense, and the business relationship of the parties involved.