Apartment Complex Property Manager Determined to be an Employee and not an Independent Contractor
(Hampton Software Development, LLC, TC Memo 2018-87)
The IRS recently won a tax court case that reclassified an apartment complex manager (who was being treated as an independent contractor) as an employee, subjecting the apartment building’s owner to employment taxes and penalties.
BACKGROUND
Beyond Federal and State income tax, current tax law subjects employers and employees to employment taxes under Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA). Employers are required to withhold FICA tax, made up of Social Security taxes and Medicare taxes, on all wages paid to employees, in addition to income tax withholding; FUTA is required to be paid by employers with respect to wages paid to employees.
To determine whether an individual is classified as an employee or independent contractor, the tax courts have historically looked at the 20 factors developed by the IRS’s common law tests. This court case was no different when applying these factors and the relevancy to the taxpayer’s situation as explained below:
FACTS OF THE CASE
Hampton Development Software, LLC (taxpayer) owned and operated a 60-unit apartment complex in Tulsa, Oklahoma. Hampton engaged Robert Herndon to provide property management services.
Hampton maintained exclusive authority to establish and change rent, policies, rules and regulations that applied to the apartment complex.
As the only person regularly performing services for the apartment complex, Mr. Herndon provided general maintenance services to the apartment complex and the apartment complex grounds, in addition to property management services.
Hampton classified Mr. Herndon as an independent contractor. Hampton did not issue Federal Form 1099-MISC to Herndon for his services. Consequently, Hampton did not withhold or pay employment or unemployment taxes with respect to the services provided by Mr. Herndon.
The IRS audit determined Mr. Herndon to be classified as an employee. In addition to assessing employment taxes on Mr. Herndon’s wages, the IRS assessed penalties under Code Sec. 6651(a)(1) and Code Sec. 6651(a)(2) for failure to file a return and pay tax and penalties under Code Sec. 6656(a) for failure to deposit employment and unemployment taxes.
To determine whether Mr. Herndon was classified as an employee or independent contractor, the tax court examined the IRS’s classification factors and broke them down into the following factors:
- Degree of control exercised by the employer. Hampton maintained control over Mr. Herndon’s work by determining when and how work was to be performed. Mr. Herndon was given specific instruction as to how the work was to be performed.
- Which party invests in the work facilities used by the worker. While Mr. Herndon provided some of his own tools to perform the daily tasks, Hampton owned most of the tools Mr. Herndon used to complete the tasks. For example, Hampton provided Mr. Herndon with a lawn mower and a company credit card to purchase materials and tools as needed.
- The worker’s opportunity for profit or loss. Herndon was paid a set salary regardless of hours worked or how successful Hampton was.
- Whether the employer can discharge the worker. Hampton had the right to discharge Mr. Herndon at any time and Mr. Herndon had the right to resign at any time.
- Whether the work is part of the employer’s regular business. Herndon’s services were an integral part of the Hampton business. His management services included replacing tenants, collecting rents, placing advertisements, etc.
- The permanency of the relationship. Herndon provided services to Hampton since Hampton’s purchase of the complex. Mr. Herndon also lived in one of the apartments of the complex located adjacent to Hampton’s office.
- The relationship the parties believed they had created. Herndon was compensated differently by outside handyman work than he was by Hampton. He submitted bids instead of receiving a set salary.
- Whether the employer provided employee benefits to the worker. Hampton didn’t provide any employee benefits to Mr. Herndon, but did provide him with paid time off.
OTHER POINTS TO CONSIDER
Other points to consider in this case:
- Regarding the 20 factors applied by the IRS; they are not all encompassing in formulating a concluding opinion.
- The taxpayer DID NOT issue any Form 1099-MISC information reporting to Mr. Herndon. During worker classification disputes, a business can seek relief from employment and unemployment taxes under Section 530 of the Revenue Act of ’79 (P.L. 95-600). In order for the business to qualify for relief under Section 530, they must demonstrate all of the following: (1) the employer has not treated the worker as an employee during any period; (2) the employer doesn’t treat any other individual holding a substantially similar position as an employee for any period; (3) the employer files all required federal tax returns on a basis consistent with treating the individual as a non-employee; and (4) the employer has a reasonable basis for not treating the induvial as an employee.
- There was no mention of an Independent Contract signed by Hampton and Mr. Herndon. An Independent Contract is highly recommended in any type of service situation.
- The IRS is not the only agency examining worker classifications. State jurisdictions will raise the issue as well. For example, Minnesota used to follow similar guidelines to the IRS when dealing with worker classification but now focuses on three main categories which essentially distills the 20-factor test. These can be found on the Minnesota Department of Revenue website.
1. Behavioral Control
2. Financial Control
3. Relationship of the Parties
CONCLUSION
The courts concluded that Mr. Herndon’s relationship did not reflect that of an independent contractor. It was also determined that taxpayer (Hampton) could not obtain Section 530 penalty relief because Hampton was unable to provide proof that the business consistently treated Mr. Herndon as an independent contractor by failing to issue 1099-MISC for his services.
When classifying an individual as an independent contractor, it is important to clearly define the working relationship between the business and the worker and to follow all federal tax return filing requirements. As demonstrated on the Hampton Software Development, LLC case, failing to follow these guidelines can have costly consequences, not just in back payment of employment taxes, but significant penalties imposed by the IRS for failing to comply with tax return filing requirements such as 1099s.
Greg I. Nelson, CPA, MBT; Ryan Kelly, CPA, MBT
Contributing Editor – Laura Huberty, CPA
Olsen Thielen CPAs