By Jeff Chang
Due to the IRS’ different treatment of private sector and public agency boards of directors, it comes as little surprise that many California special districts and public agencies continue to classify their board members as independent contractors and report their compensation on Form 1099-MISC — despite the fact that the IRS takes a contrary position.
Most tax accountants and attorneys accept that private or for-profit board directors are treated as independent contractors. However, because of their status as “public officials,” the IRS considers elected or appointed public agency board members as employees for tax withholding purposes. From there, the rules for public agency board members, as one might expect, get even more complicated.
For income and payroll tax withholding rules, the IRS treats public agency board members as “public officials” who are considered statutory employees (i.e., their income should be reported on a W-2 with income and payroll taxes withheld accordingly). However, for Social Security, Medicare and eligibility for tax-favored employee benefits (e.g., tax-free health insurance coverage or participation in an employer-sponsored 401(a) plan), the IRS relies on the common-law control test.
Although a number of California public agencies treat their board members as independent contractors for all tax purposes, a large number are now treating their board members as employees for all tax purposes after an aggressive push by the IRS to reclassify special district board members as employees for all tax purposes. The IRS has, on a number of occasions, issued private letter rulings (which can only be relied on by the requesting taxpayer) confirming its position that board members of a public agency are employees under the common-law control test. Given its position on the tax withholding and payroll tax issue, the IRS will likely challenge the classification of a special district board member as an independent contractor if it audits the agency’s payroll. If audited, an agency could become liable for unpaid income taxes, payroll taxes, interest and penalties. While there are sound arguments for treating special district board members as independent contractors, the IRS is likely to challenge that position in the event of an audit.
We have also seen this “tax identity” problem arise because a number of special districts are providing tax-free health coverage to their board members while treating them as independent contractors for tax withholding purposes. As we’ve previously explained, only common-law employees of an employer are entitled to receive tax-free welfare benefits, such as health and life insurance coverage. An independent contractor, in most cases, will not be eligible to participate in another employer’s group health plan.
If your public agency still issues a Form 1099-MISC to its board members, you should revisit this treatment with your legal counsel and make sure you have a sound basis for doing so — one that is consistent with other tax and benefit treatment.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at firstname.lastname@example.org or (916) 329-3685.