Frequently, the Internal Revenue Service and taxpayers disagree about the classification of workers as independent contractors or employees. At stake is the collection of employment taxes, as well as eligibility to participate in the employer’s retirement plan. The IRS has developed audit programs that focus on employers who “misclassify” workers as independent contractors. These IRS programs can be expensive for employers and particularly painful for small businesses that may not be able to withstand the “economic strain” of additional employment taxes. And a worker who was misclassified as an independent contractor could also put the business’s retirement and benefit plans in jeopardy for failing to cover all employees. This article contains guidelines that can be used to help determine the status of workers--whether independent or employee.
THE 20-FACTOR CONTROL TEST
In the IRS’s eyes, a worker’s status as an employee or independent contractor depends on the amount of control the employer has over the worker. The IRS has developed 20 factors to help determine the extent of this control. The importance of each factor varies depending on the kind of work being done. Lack of control isn’t necessarily shown if an employer allows a worker freedom of action. The 20 factors are:
(1) Instructions: A worker who must comply with instructions about when, where and how to work is considered an employee. An employer has control in this area if he/she has the right to require compliance with instructions.
(2) Training: Independent contractors ordinarily use their own methods and receive no training from their customers about how to do the job. On the other hand, training given the worker by the employer usually shows employee status.
(3) Integration: Employee status is often shown when a worker’s services are integrated into the business’ operations and the success of the business depends on the performance of those services. This factor may be one that works against supporting independent contractor status in nearly every situation--it’s very difficult to establish whether or not success of a business would depend on the worker’s contribution to an overall effort.
(4) Services Rendered Personally: A business which requires the worker to personally perform the services shows that the business is interested in the methods used to accomplish the tasks. This, then, shows control by the employer.
(5) Hiring Assistants: If a worker hires, pays and supervises assistants to complete a contract that requires the worker to supply materials and labor and be responsible for the result, then the worker is independent. When the employer hires, supervises and pays assistants to help the worker, employee status is indicated for the worker.
(6) Continuing Relationship: An employer-employee relationship is indicated if there is an on-going relationship between the employer and worker. This kind of relationship often exists where work is performed at frequently recurring (although irregular) intervals.
(7) Set Hours Of Work: While employees normally have set hours of work, independents set their own hours.
(8) Full-Time Work: Independents work when and for whom they choose, while employees must work full-time for a business, with restrictions on the worker being able to work elsewhere.
(9) Work Done on the Premises: Work required to be done on the employer’s premises often indicates control, especially if the work could be done elsewhere. However, control may even be present when a worker performs services in his/her own office(s). To pinpoint the importance of this factor, look at the nature of the services being performed. Control over the place of work may be indicated when the business has the right to compel the worker to travel a certain route or work at specific places. The worker should be required to work from his/her own office.
(10) Order of Sequence Set: When the employer sets the order of an employee’s duties, it shows control by the employer.
(11) Reports: If a worker must submit reports (oral or written) to the employer to account for his/her actions, control is also shown.
(12) Payments: Employee status is shown if a worker is paid by the hour, week, etc. The worker should not be guaranteed a minimum salary nor be offered any fringe benefits. If a drawing account is set up for the worker, the worker should be required to repay any excess drawn from the account over commissions earned. In effect, the job should be paid on a straight-commission basis.
(13) Payments of Expenses: If the employer pays business or travel expenses of the worker, the worker is likely to be classed as an employee.
(14) Tools and Materials: An employer furnishing all the tools and materials to do the job usually shows that an employer-employee relationship is operative.
(15) Significant Investment: An independent has significant investment in facilities or equipment used to perform services for someone else.
(16) Profit or Loss: An independent contractor can realize a profit or loss as a result of services performed. For example, a worker who has invested in expensive equipment to do a job runs the risk of incurring a heavy loss from the job. This indicates that the worker is an independent contractor. However, the risk that a worker will not be paid is not sufficient risk to categorically show independent status.
(17) Working for More Than One Business at a Time: When a worker performs services for multiple firms at the same time, independent status is indicated.
(18) Offers Service to the General Public: When a worker who regularly and consistently makes his/her services available to the general public, he/she is an independent contractor.
(19) Right to Fire: Whereas an independent can’t be fired as long as he/she produces a result that meets the specifications of the contract, an employee can be fired.
(20) Right to Quit: The reverse of (19) is true here: an employee can quit a job at any time without incurring liability. However, an independent is responsible to meet the terms of a contract.
MISCLASSIFIED AS AN INDEPENDENT CONTRACTOR
It is not uncommon to encounter a client with 1099-NEC and/or 1099-MISC income from an employer that is treating him or her as an independent contractor when your client is actually an employee.
The general distinction, of course, is that an employee is an individual who works under the direction and control of their employer while an independent contractor is a business owner or contractor who provides services to other businesses.
To determine whether a worker is an independent contractor or an employee, IRS examines the relationship between the worker and the business and considers all evidence of control and independence. The facts that provide this evidence fall into the following three categories:
(1) Behavioral control covers facts that show whether the business has a right to direct and control how the work is done through instructions, training, or other means. Employees are generally given instructions on when and where to work, what tools to use, where to purchase supplies, what order to follow, etc.
(2) Financial control covers facts that show whether the business has a right to control the financial and business aspects of the worker's job. This includes the extent to which the worker has unreimbursed business expenses; the extent of his investment in the facilities being used; the extent to which he makes his services available to the relevant market; how he's paid; and the extent to which he can realize a profit or incur a loss.
(3) Type of relationship includes written contracts describing the relationship the parties intended to create; the extent to which the worker is available to perform services for other, similar businesses; whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay; the permanency of the relationship; and the extent to which services performed by the worker are a key aspect of the company's regular business.
The above three categories condense IRS’ 20-factor test used to help determine if the employer has direction and control over an individual.