This is a copy of the response my husband sent me:....................................................................................................................... .The problem with trying to answer a complex question with a simple answer is that real life and especially the IRS and our tax code is not made up of simple statements like you can do this or you can't do that.
Our tax laws are made up of three parts:
1) What is passed by our legislators, who know little about how the system actually works and don't have to specify the practicalities of how to implement their rules when they pass them. This is referred to as the Internal Revenue Code.
2) Then the IRS makes regulations on how to actually implement what our legislators produce. This is referred to as the IRS Regulations.
3) Then the courts make decisions when someone thinks the IRS implemented poorly, although sometimes the law is written so poorly the IRS asks the courts for direction also. This is called Case Law and is actually the basis for how things really work and once things get here they are pretty much set in stone as it takes a lot (in terms of cause and money) for a higher court to over turn it.
So if you find a code section that says what you want, then you need to research if there is a regulation that modifies it and then research the court case history to see if those regulations were upheld.
The IRS publications are incomplete summaries of just one part, the IRS regulations, meant for the layman taxpayer and if you look in each one there is a disclaimer to that effect.
The "Independent Contractor" vs "Employee argument is one of the most often argued principles of tax law, but not because it is vague, but because taxpayers do not want to admit that it is not up to them to agree with another person on what they are or how they are treated. That agreement has nothing to do with the correct classification. It is strictly based on a "Facts & Circumstances" test of the relationship.
Here are the official points to use in the facts & circumstances test of the relationship between a work and an employer in classifying them as an "Independent Contractor" or "Employer". Note that the default is employee and the burden of proof in on the payer to prove that there are grounds for classifying as an independent contractor. There are only penalties for classifying someone as an "Independent Contractor" incorrectly, there is no such thing as incorrectly classifying someone as an "Employee", unless they provide no services.
Per the IRS auditors handbook, which is readily available on the internet, they are to contest any classification as an Independent Contractor if any one of these tests cannot be met.
How to tell if a worker qualifies for independent contractor status:
The following traits are indicators of independent contractor status. A worker may be an independent contractor if he or she:
Is permitted to employ assistants.
Sets the order or sequence of work.
Sets his or her own hours of work.
Works for others (in the same capacity).
Is paid by the job or by the contract completed.
Makes his or her services available to the public in the same capacity.
Has an opportunity for profit and loss.
Furnishes his or her own tools.
Has a substantial investment in his or her trade.
May be dismissed only under terms of a contract.
How to tell if a worker is an employee:
Per the IRS auditors handbook they are to contest any classification as an Independent Contractor if any three of these test cannot be met, although they have the latitude to contest when only one test if failed.
These "20 factors" indicate employee status. Under the "common law test" if an employer has the right to control, both what work will be done and how it will be done, there is an employer-employee relationship. To determine if the employer has the right to control, the Internal Revenue Service (IRS) uses the following 20-factor test. A worker is generally an employee if he/she:
Must comply with the employer's instructions about when, where and how to work.
Receives training from or at the direction of the employer. This may include having to work along with an experienced employee or having to attend meetings.
Provide services that are integrated into the business. That is, the success or continuation of the employer's business depends significantly on the performance of certain services which the worker provides.
Performs the work personally.
Hires, supervises and pays assistants for the employer.
Have a continuing relationship with the employer.
Must follow set hours of work.
Works full-time for the employer.
Do his/her work on the employer's premises.
Must do his/her work in a sequence set by the employer.
Must submit regular oral or written reports to the employer.
Receives payments of regular amounts at set intervals.
Receives payments for business and/or traveling expenses.
Relies on the employer to furnish tools and materials.
Lacks a significant investment in facilities used to perform the service.
Cannot make a profit or suffers a loss from his/her services.
Work for one employer at a time.
Does not offer his/her services (in the same capacity) to the general public.
May be fired by the employer.
May quit work at any time without liability other than losing pay.
The exemption for a spouse I believe she is referring to is being misinterpreted by her or her accountant, or her accountant is not understanding the context of her question. There is an exemption for a sole proprietorship to pay a family member, without making them an employee, but the other side of using that exemption is that the payment to the family member is not a deductible business expense, but considered part of the sole proprietors "draw". This exemption is also valid for partnerships but cannot be used by corporations, whether they are classified as a "S" or "C" type for tax purposes.
LLC's are treated according to state law and Kentucky, just like Illinois and most other states and the IRS, considers a one owner LLC a disregarded entity which is why they file the LLC's taxes on their personal return. If they are considered a disregarded entity they can use the same exemption, otherwise regardless if they elected corporate or partnership tax treatment, they cannot.
So any spouse off a studio owner would fail items 1,3,4,6,9,10,11,15,16 and probably 18 unless they work as the owner of a handyman business also. Being a handyman employee of someone else would make them fail 18 also.
And that is the simple set of tests....
If the business is a sole proprietorship or partnership the relationship cannot be independent or deductible since Section 267 of the code defines family members as Spouses, Parents & Siblings to which no amounts paid to or for the benefit of are deductible unless paid as an employee.
If the business is an "S" corporation or LLC there is a similar section copying that definition for Spouses, Parents & Siblings where either together or as a group 2% or more of the corporate stock is owned.
I have seen at least three other good cogent arguments by the IRS why this is not allowed by as you read on all of those were made esoteric last year.
When someone tries to push past of all these the IRS brings out the big, unarguable guns, which is a case that went all the way to the Supreme Court, who refused to hear it on the basis that there was no reasonable cause presented by the plaintiffs (taxpayers). That is " Donald G. Cave Professional Law Corp. v. Commissioner of Internal Revenue, T.C. Memo 2011-48". This involved a lawyer who tried to do the same thing with his wife who worked as a legal secretary elsewhere as an employee and part time for him in his one man practice. Although this is a 2011 tax court memo, it is the result of three years of litigation where he received no relief and he lost and had to pay the governments costs of prosecution.
Unfortunately this case added additional weight to the IRS position as one of the District Court's criteria was the " No one whose income was reported as the same economic entity", could be considered independent. This is no the basis they use for denying all these claims as it is better than a code reference, it is a tax court decision. So if the person you are paying is a dependent or files a joint return with you, this
In real life, in my office, I run across these questions all the time and if a client wants the simple "no you can't" from the IRS and will not settle for anything else I pick up the phone, dial 1-800-429-1040, give it to the client and tell him he has the right to ask an anonymous question on the IRS hotline, although he is free to reveal his identity if he chooses as it will not effect the answer.
Ends the debate immediately was they have always answered as soon as the taxpayer describes the situation with the phrase "so you are saying that your spouse is economically and intellectually independent from you and you exercise no control over their actions?". No matter what the client answers they get the same response. "They are an employee if you pay them, unless you consider what you pay to them as paid to you and treated the same as all the other compensation you pay yourself.".
Sometimes I wonder why I just don't start with the phone call?
Anyway that sounds like the best answer in this case!
There is also a form you can submit to the IRS, describing your potential employee\contractor relationship, and they will give you a written determination that you can legally rely on if you don't feel you can apply the tests yourself on an unbiased basis. It is form SS-8.
