A recent blog post from Nixon Peabody LLP points out that a single teleworking employee in a state can subject the employer (who otherwise doesn’t have a presence in the state) to corporate income tax in that state. The post cites to a recent Virginia Department of Taxation ruling (P.D. 13-172) stating that an employer headquartered outside Virginia was required to file a Virginia corporate income tax return on the basis that a single employee, who worked from her home office in Virginia, created substantial nexus for the employer.
It’s not the first time the commonwealth has come out with such an opinion, and it probably won’t be the last. And it’s not just Virginia. Other states have come to the same conclusion. It could spell trouble for the many employers that use teleworkers.
But is it possible for an employer to avoid creating nexus in State A, while still hiring the perfect teleworker who happens to live in State A? The Nixon Peabody blog suggests that employers can protect themselves by classifying workers as independent contractors. It's a good suggestion and one that will work in some situations -- in particular, as the blog says, for teleworkers who perform specialized tasks and “require little or no day-to-day supervision.”
It is good advice, but employers should always be cautious when considering how to classify workers. The IRS has long been interested in worker misclassification. If an employer chooses to use independent contractors, perhaps the best advice is to go in with eyes wide open. Although worker classification is often a fact-based determination, the IRS and most states have published guidance on independent contractor classification. Industry associations for those industries that are significantly affected by worker classification have also developed focus groups and in some cases published guidance or even initiated litigation regarding the issue.
The Nixon Peabody blog provides a useful outline of items employers should consider when drafting a consulting agreement. Still, there are many instances in which restricting the use of independent contractors may be advisable. The IRS uses a 20-factor test that has been termed the "right-to-control test" because it focuses on who controls the work being performed. The test follows other IRS rules and the common law concept that an independent contractor should control the manner and means by which the service is provided or the product is produced. The more aspects of the relationship that are controlled by the employer, the more likely the worker is an employee and not an independent contractor.
The IRS test is not an all-or-nothing test. That is, all 20 criteria need not be met for a worker to qualify as an employee or independent contractor, and no single criterion will make or break an employer's argument. Still, control is the key to determining whether a worker is an independent contractor or an employee.
Another test used to determine the presence of an employee relationship is the ABC test. The ABC test is similar to the common law test used by the IRS and is used by many states to determine whether a worker is an employee or an independent contractor. The three factors of the ABC test are:
- whether the individual has been, and will continue to be, free from control or direction over the performance of his or her services; and
- whether the service being provided is outside the usual course of business for the enterprise for which the service is performed or the service is performed outside all the places of business for the enterprise for which the service is being performed; and
- whether the individual is customarily engaged in an independently established trade, occupation, profession, or business.
Unless an employer can prove that all three factors have been met, the worker will be presumed to be an employee. Employers should also make sure they use whatever test is required in a particular state and not rely solely on the IRS test for state purposes.
While classifying a teleworker as an independent contractor may seem like the easy solution to avoid establishing nexus in a state for corporate income tax purposes, employers should proceed with caution. Worker misclassification has received increased attention from states and the federal government in the past few years. Misclassifying workers can be a costly mistake.