Determining who is (and is not) an employee

Determining who is (and is not) an employee by: Senen M. Quizon

The use of consultants has become a staple in business. With most businesses running a lean and mean organization, this practice has increasingly become a popular alternative to hiring employees, providing businesses a cost-effective way of filling their need for specialized skills, knowledge and expertise that are not present within the organization.
   
While there are cost benefits from treating a worker as a consultant rather than as an employee, determination of the worker’s correct tax status is important because of the difference in the tax treatment between a consultant and an employee.

The tax status (employee or consultant) of a worker determines the correct tax treatment of his income and defines the responsibility of the employer for tax purposes. Thus, any misclassification or improper classification of a worker’s status will have serious tax consequences.

This issue gains added significance in the light of current practice of some employers who hire people and designate them as consultants even if they perform the same duties or functions as a typical employee. In some instances, a retired or separated employee is re-hired as a consultant with the same position and duties.

The determination of whether an individual is an employee or a consultant is made based on the relationship that exists between the worker and the employer, i.e. whether there exists an employer-employee relationship between the concerned parties. It should be noted that under Section 2.78.3 of Revenue Regulations No. (RR) 2-98 as amended, the term “employee” is defined as an individual who performs services under an employer-employee relationship. Hence, whether a person or worker should be properly characterized as employee or consultant will depend on the existence of employer-employee relationship.

The presence of employer-employee relationship is established using the criteria/test prescribed under Section 2.78.3 of RR 2-98, as amended, under which the employer: (a) 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 the result is accomplished; (b) has the right to dismiss; and (c) furnishes the tools and place of work.

In addition, the Bureau of Internal Revenue (BIR) also relies on existing jurisprudence for guidance in determining the worker’s employment status. Case law has consistently held that the employer-employee relationship is established using the four-fold test: (a) the selection and engagement of the employee; (b) the payment of wages; (c) the power of dismissal; and (d) the employer’s power to control the employee on the means and methods by which the work is accomplished.

Although there is no single factor whose presence will define the worker’s status or relationship, it is the control test which is given the most weight by prevailing jurisprudence as well as in BIR rulings and RR 2-98, as amended, in determining the existence of employer-employee relationship.

Applying these tests, mere designation of a worker as a consultant does not automatically confer upon such person the status of a consultant. If the employer exercises control not only of the result but also of means or methods by which the work shall be accomplished, the worker shall be treated as an employee for tax purposes. Consistent with this, the BIR had the occasion to rule that the presence in the service contract of a provision that there is no employer-employee that exists between employer and personnel would not negate the existence of the relationship. Hence, after having established that the employer exercises the right to dismiss, and control over the personnel not only as to result but also in the manner the result will be accomplished, the BIR held that the contractual personnel should be considered employees, and therefore subject to withholding tax on compensation, instead of ex panded withholding tax on professionals (BIR Ruling No. DA-098-01, May 21, 2001).

Hiring an employee gives rise to an obligation from the employer to withhold tax on compensation while engaging a consultant imposes upon the employer the obligation to withhold the 10% or 15% expanded/creditable withholding tax. Thus, when an employee is misclassified as consultant, the employer may be assessed for deficiency withholding tax on compensation plus penalties in respect of late payment of withholding tax. On the other hand, where it is established that an employee is really a consultant, the employer shall be liable for deficiency expanded/creditable withholding tax and penalties for late remittance of taxes.

Misclassification will also involve amendments in the alphalists (e.g., monthly alphalist of payees, annual alphalist of employees) filed by the employer, and cancellation and issuance of BIR Form 2307 or BIR Form 2316, as the case may be.

For consultants who are reclassified as employees, a recomputation of their tax due, as well as amendment of their previously filed income tax return (BIR Form 1701) shall be done. In this regard, it should be noted that while both income of employees and consultants are subject to the 5-32% graduated income tax rates, employees who are earning purely compensation income are allowed to deduct only personal and additional exemption allowances and health and/or hospitalization insurance premiums in arriving at their net taxable income.

On the other hand, consultants are allowed to deduct the same types of deductions allowed corporations, or 40% optional standard deduction, in addition to personal and additional exemption allowances and health and/or hospitalization premiums. Hence, if it is determined that the worker is really an employee, the income tax due needs to be recomputed, and an amendment of his/her previously filed return (BIR Form 1701) should be made. If there is unpaid tax, interest and compromise penalty upon filing of the amended return.

Also, as a result of his/her recharacterization as employee, such worker may under certain conditions qualify for substituted filing, and in this case, since he/she is no longer required to file a return, the previously filed return (BIR Form 1701) may also need to be amended. This will also require an update of BIR registration of concerned worker.

In case of an employee reclassified as a consultant, this will again require a recomputation of his/her income tax due, and amendment of his/her previously filed return. If no return was previously filed since the worker as employee qualifies for substituted filing, the filing of income tax return (BIR Form 1701) covering his/her income as consultant is required. In addition to income tax, the reclassification of employee as a consultant may lead to assessments for failure to register and payment of 3% percentage tax on gross receipts or 12% value added tax if the annual gross receipts exceed P1,919,500.

When engaging the services of consultants, the contract may indicate a consultant, but the tax status of the worker will not be determined solely by this fact. In addition to considering the terms and conditions of the service contract, reference must be made to the criteria or tests prescribed under RR 2-98 and existing jurisprudence to ensure proper determination of the worker’s status. To this end, every employer must take steps to ensure he properly characterizes workers’ relationships so as to prevent imposition of costly penalties and complications arising from improper classification of workers’ status for tax purposes.