Chapter 5 - Employment Taxes - Hardwood Timber Industry
OVERVIEW
The potential for raising significant employment tax issues during an audit of a timber industry tax return is very good. This is so for many reasons. One of the most common reasons is the misclassification of employees as independent contractors.
An employer must withhold, under the Federal Insurance Contributions Act ("the FICA"), social security and Medicare taxes from wages paid to employees, and is liable for an equivalent amount of social security and Medicare taxes on the wages. The employer must also pay the taxes imposed under the Federal Unemployment Tax Act ("the FUTA") and must withhold federal income taxes from the wages. In addition to these federal requirements, the employer may be responsible for state unemployment taxes and the withholding of state and local income taxes. Employees may also be eligible for certain tax-favored company benefits that are not available to independent contractors. Independent contractors do not have taxes withheld from their remuneration and the ',employer" is not liable for the employer's share of FICA taxes or the FUTA tax. Their responsibilities under state law also change. Consequently, the employer can save money by treating the workers as independent contractors.
The employer also saves time money, and energy on significantly reduced paper work. With employees, in addition to the bookkeeping, the employer must deal with many tax forms. With independent contractors, the only paper work is the writing of a check and entering it into the Cash Disbursements Journal.
Some of the Federal forms necessary to be filed with respect to employees are as follows:
- Form 940, Employer's Annual Federal Unemployment Tax Return
- Form 941, Employer's Quarterly Federal Tax Return
- Form W-2, Wage and Tax Statement
- Form W-3, Transmittal of Wage and Tax Statement
- Form W-4, Employee's Withholding Allowance Certificate
Employers who pay independent contractors, whether misclassified or not, may be required to file the following forms:
- Form 1099-MISC, Miscellaneous Income Statement
- Form 1096, Annual Summary and Transmittal of U.S. Information Returns
Form 1099-MISC is required to be filed for each person to whom at least $600 in rents, services (including parts and materials, see Rev. Rul. 81-232, 1981-2 C.B. 231), prizes and awards, and medical and health care payments has been paid. Payments are to be reported only by persons engaged in a trade or business when the payments are made in the course of such trade or business. Personal payments are not reportable. In addition, Form 1099-MISC is not required to be filed if the recipient of the miscellaneous income receives less than $600 per year; however, it is still taxable to the recipient. Also, Form 1099-MISC is not required to be filed if the recipient is a corporation.
Form 1099-MISC is to be filed with the Internal Revenue Service by February 28; Form 1099-MISC is to be furnished to the recipient by January 31.
There is no penalty for filing a Form 1099-MISC that is not required to be filed. However, there is a penalty for failing to file or filing with incorrect information any required Form 1099-MISC. The amount of the penalty is based on when the correct information returns are filed. The penalty is:
- $15 for each information return if correctly filed within 30 days after the due date with a maximum penalty of $75,000 per year ($25,000 for small businesses).
- $30 for each information return if correctly filed more than 30 days after the due date but by August i, with a maximum penalty of $150,000 per year ($50,000 for small businesses).
- $50 for each information return if correctly filed after August 1 or not filed at all, with a maximum penalty of $250,000 per year ($100,000 for small businesses).
- At least $100 for each information return if the failure is due to intentional disregard of the filing requirements, with no maximum penalty.
For further information on Form 1099-MISC, request "Instructions for Forms 1099, 1098, 5498 and W-2G."
WHO ARE EMPLOYEES?
Guides for determining a worker's employment status are found in three substantially similar sections of the Employment Tax Regulations; namely, sections 31.2121(d)-1, 31.3306(i)-1, and 31.3401(c)-1, relating to the FICA, the FUTA, and federal income tax withholding, respectively.
In general, it should be noted that section 3121(d) (2) requires the application of the common law rules in determining the employer-employee relationship. In determining whether an individual is an employee under the common law rules, twenty factors have been identified as indicating whether sufficient control is present to establish an employer-employee relationship. The twenty factors have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which services are performed, as explained in Rev. Rul. 87-41, 1987-1 C.B. 296, which sets forth the factors. (The twenty factors are discussed in detail in IRM Section 4646 and Exhibit 4640-1.) The twenty factors are not to be applied mechanically, like a scorecard. Rather, they are to be used as an aid in applying the common law. See also Nationwide Mutual Insurance Co. v. Darden, 112 S.Ct. 1344, 1348 (1992).
Although a variety of factors may be used to analyze employment status for tax purposes, the regulations provide that the relationship of employer and employee generally exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.
The examiner should begin by gaining an understanding of the way a company operates rather than simply trying to verify the presence or absence of common law factors. The examiner should focus on what the business does and how the job gets done. It is also important to understand the relationship between the employer and its clients or customers.
Next, the examiner should establish which of the "20 common law factors" listed in Re. Rut. 87-4t are relevant in analyzing control for this kind of work. The examiner should also consider whether factors not listed in Re. Rul. 87-41 may also be relevant. For example, required attendance at meetings may be relevant in determining whether the employer has retained the right of control.
After determining the relevant factors, the examiner should consider the relative weight of these factors in determining worker status. The examiner then needs to weigh the facts and circumstances of each case and determine worker status accordingly.
STATUTORY EMPLOYEES
"Statutory employees", described in section 3121(d) (3) of the Code, are not employees under the common law rules. The Code treats statutory employees as common law employees for purposes of imposing taxes under the Federal Insurance Contributions Act ("FICA"); however, the Code does not allow employers to withhold income tax from payments to statutory employees just as the employer does not withhold income tax from payments to independent contractors. Employers may be required to pay taxes under the Federal Unemployment Tax Act ("FUTA,,) for certain statutory employees.
Once a person realizes that he does have workers who are employees, the person should obtain an Employer Identification Number (EIN). The EIN is a nine-digit number the IRS issues to identify accounts for employers. To Obtain an EIN, request Form SS-4, Application for Employer Identification Number.
Example 1
You are given the tax return of Maple Logging, Incorporated to examine. During your pre-contact you note that the corporation does $3 million in gross receipts, yet pays minimal wages, salaries, and cost of labor. However, in the schedule detailing other deductions, sub-contracting expense is over $500,000. Per the return, depreciation is several hundred thousand dollars. The depreciation schedule is attached to the return, which reflects numerous trucks, logging equipment, etc. Also, during the review of the tax return, you notice that insurance, fuel, repair, and tire expense is substantial.
As a result, you informed Mr. Sapp that his workers have been misclassified as independent contractors and that you will prepare reports to correct the misclassification for the prior years. Mr. Sapp will now be responsible for withholding federal income tax and the Federal Insurance Contribution Act (FICA) taxes from his workers; he will also be responsible for paying FICA taxes and paying into unemployment funds. In addition, you asked him for the names of his competition.
Example 2
You are given the tax return of Woodchuck Wood Cutters, Inc. to examine as a result of an Information Report filed by an informant. The informant states that the owner of Woodchuck, Mr. Brown, treats all of his workers as independent contractors, when, in fact, they are employees. Woodchuck hires workers to fell trees using his equipment. To make it appear that the workers are contractors, Woodchuck requires them to lease his saws for a fee. Woodchuck does issue 1099-MISCs.
As a result, you decide to audit the return, limiting the scope to employment taxes only.
At the initial interview, Mr. Brown informs you that Woodchuck has no employees. His wife maintains the books and records and takes care of all business calls. Mr. Brown maintains his office in the home. Neither Mr. nor Mrs. Brown receives any compensation. All of his workers are independent contractors who lease Mr. Brown's equipment. In addition, you learn the following:
Woodchuck does not require the workers to use their own equipment. As a matter of fact, Woodchuck requires that they use its equipment, which it leases to them for a fee. Mr. Brown states that this is to ensure that the equipment is properly maintained.
The workers are paid every other Friday; Woodchuck deducts from their paycheck the value of the leased equipment
None of the workers are required to have liability insurance; coverage is provided by a group policy through Woodchuck Wood Cutters, Inc.
The workers often purchase oil, gas, etc. Woodchuck reimburses them only if they provide original receipts for reimbursement.
Woodchuck requires that the workers wear protective eyeglasses and steel-toed shoes. Anyone who does not wear the protective clothing is not permitted to work. Woodchuck gives each worker who has been with the company one year $100/yr. for protective clothing.
The work day begins at 7:30 a.m. and ends at 4:30 p.m.; those who frequently report to work late are fired.
At the conclusion of this interview, you asked Mr. Brown why these workers were not treated as employees. He responded that they were not employees because they had to lease Woodchuck equipment; therefore, they must be independent contractors.
You informed Mr. Brown that the common law rules govern whether a worker is an employee or an independent contractor. As an aid in making this determination, the Service uses a list of 20 employment related factors. It may be true that the workers provide their own equipment, by leasing them from Woodchuck. However, there are numerous other factors which clearly establish the employee-employer relationship. For instance, Woodchuck has the right to fire; it furnishes the insurance; it reimburses documented business expenses; it requires protective clothing be worn; and it determines the method and result of the services.
Based on the circumstances of the employment relationship between Woodchuck and its workers, Woodchuck has the right to control its workers, and accordingly, the workers are Woodchuck's employees.
Woodchuck acquiesced to the reclassification. Therefore, inform Mr. Brown that the workers have been misclassified as independent contractors and that you will prepare reports to correct the misclassification for the prior years. However, Woodchuck will now be responsible for withholding federal income tax and social security taxes (FICA) from its workers; it will also be responsible for matching the FICA takes and paying into unemployment funds.
Example 3:
You are given the tax return of Mr. Landowner to examine. Mr. Landowner sold 100 acres of timber to Geso's Logging for a lump sum price of $150,000. Geso's Logging contracts Buckner's trucking to haul the logs from the landing to Blackwater Sawmill for a fee of $75 per MBF, totaling $75,000. Blackwater Sawmill purchases the logs for $345,000 and is requested to cut three checks as follows:
To: Mr. Landowner $150,000
Geso's Logging 120,000
Buckner's Trucking 75,000
Who is responsible for the filing of Form 1099-MISC?
a. Mr. Landowner is not required to file the Form 1099-MISC.
b. Geso's Logging is required to file From 1099-MISC to Buckner's Trucking for $75,000. However, Geso's Logging is not required to report the lump sum purchase of standing timber; this transaction is considered to be a real estate transaction and no reporting is required because the transaction is excluded from the proposed real estate reporting requirements.
c. Buckner's Trucking is not required to file Form 1099-MISC.
d. Blackwater Sawmill is not required to file Form 1099-MISC. However, had Mr. Landowner been paid by Geso's Logging at a specified rate for each unit of timber actually cut under a pay-as-cut contract, the payment for that timber would be a royalty, which must be reported on Form 1099-S provided the recipient is not a corporation.
In addition, the purchase of logs for a lump sum is not a royalty arrangement and the payment is not required to be reported because it is a payment for merchandise under IRC Reg. 1.6041-3(d) . The payment to a contractor for a total amount that covers the purchase of timberland the service of cutting is also excludable from reporting as the payment of a bill for merchandise. Finally, the payment to an independent contractor for cutting timber is compensation for services performed, and payments of $600 or more must be reported as Non-Employee Compensation on Form 1099-MISC.
SAW RENTS
It is common in the timber industry for employees to furnish and maintain their own saws and related equipment. Employers frequently reimburse their employees for the "rental" of the employee-owned saws and related equipment. Typically, the employer will treat a certain percentage of each employee's wages as a reimbursement. These reimbursement payments are customarily called "saw rental payments"; however, the payments usually do not represent a payment of rent made by the employer to the employee for the employer's use of the saw. Although the payment may be intended to reimburse the employee for the expenses incurred in purchasing and maintaining a saw, the amount is generally determined without reference to the expense that might be incurred. It is more likely that the reimbursements are used to provide employee compensation that is not subject to employment taxes. Employers do not include the reimbursements in the employees' wages. Consequently, the employers reduce their liability for employment taxes.
Internal Revenue Code Section 62(a) defines Adjusted Gross Income (AGI) as gross income minus certain deductions. These deductions are allowed without regard to whether or not the taxpayer itemizes; nor are the deductions subject to the 2% AGI floor.
Section 62(a) (2) (A) of the Internal Revenue Code allows an employee a deduction in computing adjusted gross income (an above-the-line deduction) for expenses paid by the employee, in connection with the performance of services as an employee, under a reimbursement o9 other expense allowance arrangement with the employer, i.e., an accountable plan.
The issue with respect to saw rents is whether employees who furnish and maintain their own saws and other equipment are reimbursed for such expenses under an accountable plan. This is because IRC section 62(c) provides that a nonaccountable plan will not be treated as a reimbursement or expense allowance arrangement for purposes of IRC section 62(a) (2) (A). Nonaccountable plans are those under which (1) the employee is not required to substantiate the expenses covered by the arrangement to the person providing the reimbursement, or (2) the employee has the right to retain amounts in excess of the substantiated expenses covered under the arrangement.
Amounts received under a nonaccountable plan are included in the employee's gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to withholding and payment of employment taxes. Expenses reimbursed under a nonaccountable plan, if deductible, are deductible by the employee only as a miscellaneous itemized deduction, subject to the 2 percent floor imposed by IRC section 67. However, if the expenses are determined to be personal, they are not deductible by the employee under any provision of the Internal Revenue Code.
The amounts reimbursed to employees for the rental of their own saws and other equipment will not qualify as received under an accountable plan unless three requirements are met. First, under section 1.62-2(d) of the Income Tax Regulations, the expenses for which the employer is making payment must be expenses that would qualify for a business expense deduction under IRC section 162. Second, the substantiation requirements of section 1.62-2(e) must be met. Third, under section 1.62-(f), the employee must be required to return, within a reasonable period of time, any amounts received in excess of those that have been substantiated.
If an arrangement meets all three of these requirements, section 1.62-2(c) (2) provides that all amounts paid under the arrangement are treated as paid under an accountable plan. Under section 1.62-2(c) (4), the amounts treated as paid under an accountable plan are excluded from the employee's gross income, are not required to be reported on the employee's Form W-2, and are exempt from the withholding and payment of employment taxes. Section !.62-2(c) (3) provides that if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan.
Saw rental payments do not satisfy the accountable plan requirements for two reasons. First, the employer is making a payment for expenses that may not be incurred. This violates the requirement that the expenses for which the employer is making payment must be deductible under IRC section 162. Second, there is no substantiation required. Accordingly, the saw rental payments are paid under a nonaccountable plan.
Example:
Lyle's Logging hires employees to fell 10 tracts of timber during the month of June. The employees provide their own saws and miscellaneous equipment. Lyle pays his employees $10 for each tree felled; generally, fifty trees per day are felled. Lyle apportions the payments to his employees 75% as wages and 25% as saw rents. Lyle has no idea if the saw rents reasonably correspond with the anticipated expenses of saw rents. None of the employees are required to substantiate any business expenses. Lyle frequently pays cash allowances and relies on the expectation that the allowance will be used for bona fide business expenses. Lyle reported only the 75% wages paid on the employees' W-2s at the end of the year. No consideration was given to the 25% saw rents.
During the audit of this company, you determine that the employees were reimbursed for employee business expenses under a nonaccountable arrangement. Therefore, the total paid to the employees, wages and saw rents, is includable in income and reportable as wages subject to employment takes. Your Revenue Agent's Report reflects the employment taxes due.
In addition, you request RTVUEs of the employees' returns to determine if the total Paid by the employer to the employee was correctly reported. The employees are entitled to claim any unreimbursed employee business expenses only if they itemize subject to the 2% AGI floor.
SKIDDER RENTALS
A skidder is a four-wheeled machine which is used to move felled trees. A skidder is not driven on the road. New skidders cost approximately $100,000; used skidders, $25,000. Skidder Operators often own their own skidders and pay for the costs of operating and maintaining the skidders.
It is common in the timber industry to find skidder operators who provide their own skidders to perform services as employees. The employer generally pays the skidder operator a predetermined amount based on the number of logs hauled. Often, there is no written agreement between the employer and the skidder operator; the agreement is usually verbal. It is customary to find employers paying 60% of the amount paid to the skidder operators as "skidder rent." The balance or 40% of the amount paid represents wages. Of course, the employer does not subject the 60% skidder rent to any employment taxes. The employer may or may not report the skidder rental to the operator on a 1099-MISC.
Unlike the saw rent discussed earlier, skidder rental payments may not be a reimbursement for employee business expenses governed by IRC section 62. The rental paid to a skidder operator will be considered self-employment income to the skidder operator who is engaged in the trade or business of renting the skidder. Whether a skidder operator is engaged in a trade or business is a factual question and requires an examination of the facts in each case to determine whether the operator was engaged in the activity with continuity and regularity and with a primary motive for income or profit. If the operator is engaged in a trade or business, the operator does not have to report the skidder-rental as wages. The skidder operator must report the skidder-rental as self-employment income and subject to self-employment tax.
Whether the payment made to the skidder operator actually is the payment of rent is also an issue to consider with skidder rental payments. An analysis of the arrangement may reveal that the payments look more like a reimbursement for employee business expenses. In that case, the IRC section 62(c) analysis is appropriate.
Example:
Lyle's Logging hires a skidder operator to skid the felled trees from the I0 tracts of timber as in the previous example.
The skidder operator is to be paid $20,000. Of the $20,000, Lyle designates 60% or $12,000 as skidder rental, which he does not subject to any employment taxes or withholdings. Lyle's designates 40% or $8,000 as wages. Lyle gives the skidder operator a W-2 for $8,000 at the end of the year. As Lyle assumed the skidder operator was incorporated, he did not issue him a 1099.
During the audit, you verify that the skidder operator, who is not incorporated, correctly reported on Line 7 of Form 1040, the wages paid to him of $8,000. You also learn that the skidder operator reported the skidder rental of $12,000 on Schedule E. You inform the skidder, operator that the skidder rental is not rental income to be reported on Schedule E. Instead, the skidder rental is self-employment income subject to self-employment tax as the skidder operator was in the trade or business of renting the skidder. As a result, the skidder rental should have been reported on Schedule C, as the operator is not incorporated.
Your Revenue Agent's Report reveals self-employment tax due attributable to the misclassification of skidder rental as rental income rather than self-employment income. In addition, you advise Lyle's Logging that a 1099-MISC should have been issued to the skidder operator as the operator was not incorporated and his services exceeded $600 for the year.