Tax-exempt organizations often refer to individuals who assist with various activities related to the exempt purpose of the organization as “volunteers.” However, many organizations may be surprised to learn that these individuals are actually “unpaid employees.” Even more surprisingly, if the unpaid employee receives cash or cash equivalents from the tax-exempt organization in appreciation for their services, the compensation is deemed to be taxable wage income and is reported on Form W-2. The organization can gross up the payment to provide the employee tax-free income. However, this income is reported on a W-2 because the worker is classified as an employee and not an independent contractor.
For federal tax purposes, it is critical for employers to correctly determine the status of individuals providing services to the organization. If a volunteer who is an unpaid employee receives compensation, that compensation must be reported correctly. Misclassifying a worker as an independent contractor and not an employee may adversely affect the worker, because their share of taxes is not withheld from their pay. Additionally, an employer may be held liable for unpaid employment taxes on that worker. In general, a business must withhold and pay income taxes, Social Security and Medicare taxes, and unemployment taxes for an employee.
IRS Principles for Determining Independent Contractor vs Employee Status
How does an organization determine if a worker is an employee or an independent contractor? To make this determination under IRS rules, the relationship between the worker and the business must be examined. The employer’s degree of control and the employee’s degree of independence are considered when making this determination. The IRS uses three principles that employers should consider when undertaking this analysis: behavioral control, financial control and type of relationship.
Behavioral Control
Does the organization have the right to direct or control how the worker completes their work?
If the organization instructs how, when and where to do the work, and provides the supplies to use, it is controlling how the worker is to complete the task. Also, if the worker receives training, this indicates that the organization wants the work performed in a certain manner. These behavioral factors may point toward an employer-employee relationship. Conversely, if a business lacks the knowledge to perform certain tasks and requires specialized professionals to perform those tasks, the business may provide little to no instruction. This lack of control may point toward independent contractor status. The main consideration is whether the business has retained the right to control the details of the worker’s performance or has given up that right. An analysis of these behavioral control factors will help determine the individual’s status as an employee or an independent contractor.
Financial Control
Does the organization have the right to control the business aspects of the worker’s job?
This includes looking at unreimbursed business expenses. Independent contractors may incur more unreimbursed expenses than employees; however, employees may incur these expenses as well. An independent contractor may have a significant financial investment in the performance of their work such as tools, trainings and facilities used. Another consideration is how the worker is paid. Employees are often paid on an hourly basis and receive compensation at regular intervals. Independent contractors are typically paid a flat fee or payment is made based when milestones are reached. Regarding compensation, if the worker can realize a profit or loss, this role will typically be considered an independent contractor.
Type of Relationship
The perception of the two parties involved in the business relationship is especially important.
Does the worker expect to receive benefits such as insurance, pension, paid leave or other benefits?
This may point toward an employer-employee relationship. If the length of the business relationship is indefinite rather than limited to a specific period, this may create an employer-employee relationship. If the services provided by the worker are a key aspect of the business’s regular activities and the business has the right to direct and control the worker’s activities, this may also indicate an employer-employee relationship. A written contract may provide clarity when evaluating employee or independent contractor status and is significant when other factors are not clear.
A business must weigh all the factors when determining the worker’s status, and no single factor will provide the answer. A business must look at the entire relationship and the extent to which the organization directs and controls the worker to best classify the worker as an employee or independent contractor. Factors that are relevant in one situation may not be relevant in another. Thus, all factors must be considered.
Department of Labor Rules for Determining Independent Contractor vs Employee Status
The considerations discussed above are what the IRS looks at to determine if an employer-employee or independent contractor relationship exists, and to determine how the worker is classified for federal tax purposes. However, the Department of Labor (DOL) provides a different analysis employers must consider to properly classify a worker as an employee or an independent contractor, solely for purposes of the federal Fair Labor Standards Act, which governs federal minimum wage and overtime rules. Employee misclassification may deny a worker basic rights and protection relating to minimum wage and overtime pay, given that independent contractors are not afforded this protection.
In January 2024, the DOL’s Wage and Hour Division issued final independent contractor rules for employee benefit plans that were effective on March 11, 2024. Under the DOL rules, an organization must look at six factors to determine independent contractor status:
In January 2024, the DOL’s Wage and Hour Division issued final independent contractor rules for employee benefit plans that were effective on March 11, 2024.
Under the DOL rules, an organization must look at six factors to determine independent contractor status:
1. Opportunity for profit or loss depending on managerial skill
The primary factor is whether a worker can generate profit or suffer losses through independent factors. These factors include negotiating pay, declining work, hiring workers, purchasing material and engaging in activities that expand their services such as marketing and advertising. The more factors the worker manages, the likelier the relationship will lean toward an independent contractor relationship.
2. Investments by the worker and the employer
This factor looks at the worker’s investments that are capital or entrepreneurial in nature that will generate business growth and increase clients and sales. A lack of capital investment or entrepreneurial engagement favors employee status.
3. Degree of permanence of the work relationship
This factor looks at the nature and length of the work relationship. Sporadic and project-based work indicates independent contractor status. Conversely, work that is continuous without a fixed end date indicates employee status.
4. Nature and degree of control
This primary factor looks at the level of control the employer has over the performance of the work and the economic aspects of the relationship. Factors to consider are hiring, firing, scheduling, pricing, pay rates and supervising the performance of the work. The more control the potential employer has over these aspects, the more the relationship with the worker leans toward employee status.
5. Extent to which the work performed is an integral part of the potential employer’s business
This factor considers whether the work is a critical, necessary or central part of the potential employer’s principal business. If the work performed by the worker is a critical, necessary and central part of the business, this indicates an employee relationship.
6. Skill and initiative
This factor looks at whether the worker uses specialized skills together with business planning to perform the work and grow the business. Both an employee and independent contractor may have specialized skills, so that factor does not indicate a slant toward one status or the other. However, the worker’s skills in addition to business development may indicate independent contractor status.
If an employer-employee relationship exists and the work falls under the FLSA, then the employee must be paid minimum wage and appropriate overtime pay, and the employer must adhere to recordkeeping requirements as well as child labor provisions.
Misclassifying an employee as an independent contractor can also affect:
- Retirement plans
- Health and welfare plans
- Other benefits/nonqualified plans
Employers should be aware of the current and retroactive consequence that may result if workers are misclassified.
The rules issued by the DOL Wage and Hour Division look at the individual’s activity to determine if they are an independent contractor, whereas the IRS considers the degree of control the employer has over the individual. However, some confusion may exist because organizations think they should use the DOL rules to classify workers as either employees or independent contractors for federal tax purposes. Ultimately, the DOL final rules under the FSLA have no effect on how the IRS distinguishes between employees and independent contractors. Organizations must follow the federal tax code – not the DOL rules — to determine if a worker is an employee or independent contractor for federal tax reporting purposes.
Volunteers Are Most Likely Unpaid Employees
Many organizations use volunteers for services and many of these volunteers are not compensated for their services. Giving back is a purposeful experience for many of these volunteers. However, when organizations compensate volunteers for services, this may lead to unintended consequences for organizations if they do not understand the rules.
The Internal Revenue Code (IRC) does not specifically address whether volunteers are unpaid employees. Therefore, organizations must look at other sources for guidance. The IRS Office of Chief Counsel has issued several Chief Counsel Advice (CCA) memoranda addressing this topic. For example, in CCA Memorandum 200025050, the Chief Counsel was asked to address a program where senior citizens working for municipalities received a reduction in property taxes in exchange for their services. The workers were called “volunteers.” Consideration was given to the definition of “wages,” “employment” and “employee.” Based on the facts provided, the IRS stated that “it is virtually certain that temporary, minimum wage workers hired to work off their property tax liability will be employees, not independent contractors.” The reduction in the property taxes was considered an in-kind payment in exchange for services rendered by the volunteers and resulted in taxable income to the volunteers.
- Consideration was given to these facts:
- Compensation was limited to minimum wage.
- Clerical or routine work was assigned to the workers.
- The workers were under the direction of the municipality, were not engaged in an independent trade or business, were not working independently without supervision, and were not offering services to the public.
- An economic loss would not result from the services performed.
The factors noted above were evaluated in determining that the workers, even though they were referred to as volunteers, should be considered employees.
CCA Memorandum 200302045 also addressed the question of property tax relief. This CCA discussed a program whereby emergency responders were given property tax relief if they volunteered their services as emergency responders. Again, the conclusion was that “the performance of services in return for a benefit, whether it is in the form of money, property, fringe benefit, etc., has long been a taxable event under IRC Section 61 as compensation for services.”
Keep in mind that Chief Counsel Advice responses are not legally binding. If an organization wants a determination on whether a worker is an employee, it may want to consider filing IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Organizations should be aware that if they compensate volunteers with cash or something other than cash, the compensation is subject to tax withholding.
Summary
Organizations should consider the following:
- Organizations should be aware of employment tax issues when volunteers provide services and the volunteers are compensated for those services.
- Misclassifying a worker as an independent contractor may result in an organization incurring employment taxes and may result in the assessment of interest and penalties.
- For federal tax purposes, a worker is classified as either an employee or an independent contractor. It is extremely rare for the same worker to receive both a Form W-2 and a Form 1099-NEC from the same organization. Providing a W-2 and a 1099-NEC to the same individual from the same organization can trigger IRS investigations.
- Organizations should use the three principal categories established by the IRS to analyze the relationship between an entity and a worker for federal employment tax purposes.
- An organization can file Form SS-8 and the IRS will determine the status of a worker for federal employment taxes and income tax withholding
Conclusion
Volunteers are the backbone of many tax-exempt organizations. These workers provide invaluable services to enable organizations to administer their tax-exempt purpose. Determining an individual’s status as a volunteer, an employee or an independent contractor may be confusing for some organizations. When an organization is conducting the analysis, it must remember that for federal tax purposes, it must follow the rules established by the IRS, and consider these factors: behavior control, financial control and type of relationship.
Written[CM1] by Linda Thomas. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com
[CM1]This footnote must be printed with any Alliance Firm re-use.
