Businesses often prefer to treat workers as independent contractors to lower their costs and administrative burdens. But the IRS, the U.S. Department of Labor, various state agencies or even the employees themselves may challenge an employer’s classification. The U.S. Tax Court considers seven factors when deciding whether to classify workers as employees or independent contractors. But states have their own tests for determining employee status.
Note: To make things more understandable, we will call businesses that hire workers “employers” (whether the workers are employees or independent contractors), and we’ll call the individuals who get the job done “workers” (whether they’re employees or independent contractors).
Common-Law Employee vs. Independent Contractor
Common-law employees are workers considered to be employees (as opposed to independent contractors) based on various statutes, regulations and court decisions. IRS and DOL rules can differ from state and local rules. That said, if an employer is allowed to treat a worker as an independent contractor under IRS rules, it will generally be the same across the board. But not always as the recent FedEx cases demonstrate (see the right-hand box).
Properly classifying a worker as an independent contractor is beneficial because the employer doesn’t have to worry about employment tax issues or provide expensive fringe benefits.
However, when an employer mistakenly treats an employee as an independent contractor, the employer could owe unpaid employment taxes, as well as interest and penalties. The employer also may be liable for employee benefits that should have been provided but were not. So, it’s important to get worker classification questions right.
Seven Factors to Decide Worker Classification
The Tax Court considers these factors when deciding whether workers should be classified as independent contractors or employees for federal employment tax purposes:
1. Degree of Control. When an employer exercises significant control over how a worker performs duties or has the right to do so, this factor indicates employee status. When there’s little or no control or right to exercise it, this factor indicates independent contractor status.
2. Investment in Equipment and Facilities. When the worker covers most or all of the cost of equipment and facilities used for the job, this factor indicates independent contractor status. For example, say the worker performs his duties out of an office in his home using equipment (computer, printer and phone) that he pays for himself. In such a case, this factor would clearly indicate independent contractor status. On the other hand, if the employer provides most or all of the equipment and facilities, this factor would indicate employee status.
3. Whether the Worker Has an Opportunity for Open-Ended Profit or Outright Loss. A worker who can make an open-ended profit through the strength of his or her own efforts or, alternatively, can suffer an outright loss on the job, is likely to be an independent contractor rather than an employee. For example, this would be the case when an outside sales person is paid by commission only.
On the other hand, when the compensation arrangement dictates that the worker can only make a fixed profit and not suffer a loss, it indicates employee status. For example, this would be the case when the worker is paid a fixed amount for each day of work and the only significant job-related expense is the cost of commuting to and from the work site.
4. Whether the Worker Can Be Discharged. A worker who can be discharged is more likely to be an employee than an independent contractor.
5. Whether Work Is Related to Employer’s Core Business. When the worker’s duties relate to the employer’s core business it indicates employee status, while work related to a tangential enterprise indicates independent contractor status.
6. Permanency of Relationship Between the Employer and Worker. Lack of permanency indicates independent contractor status while permanency indicates employee status.
7. Relationship the Employer and Worker Believed they Were Creating. If the employer and the worker believed the same thing at the time they entered into their arrangement, courts rule this factor can indicate either employee or independent contractor status, depending on the facts. If the parties believed two different things, this factor may be thrown out.
A Closer Look at Degree of Control
Based on longstanding tradition, the degree of control is the most important of the seven factors the Tax Court uses to decide whether a worker is an employee or independent contractor. It’s often used as the tie-breaker in situations where there are an equal number of factors on both sides.
The IRS has developed a 20-factor control test based on common law principles that have evolved in the courts. The following factors are used to determine the degree of control an employer has over the worker in order to establish an employer-employee relationship:
- Employer provides instructions to worker.
- Employer provides training to worker.
- Worker is integrated into business operations.
- Employer requires the services be rendered personally by the worker.
- Employer hires, supervises and pays the worker’s assistants.
- The relationship between the employer and worker is continuous (or permanent).
- Employer sets the hours of work.
- Employer requires full-time work.
- Work is performed on employer’s premises.
- Employer sets the order or sequence of work.
- Employer requires oral or written reports from the worker.
- Employer pays worker by the hour or week.
- Employer pays worker’s business and/or traveling expenses.
- Employer furnishes worker’s tools and materials.
- Worker is not required to make a significant financial investment.
- Worker does not realize profit or loss.
- Worker does not perform services for more than one business at a time.
- Worker’s services are not available to the general public.
- Employer has the right to discharge worker.
- Worker has the right to terminate relationship.
To the extent that these factors are present, the employer has control over the worker. The higher the degree of control, the more likely it is that the IRS will classify a worker as employee, not an independent contractor.
Why Worker Classification Matters
When a worker is properly classified as a common-law employee, the employer generally must withhold federal income and employment taxes from the worker’s wages. The employer must also comply with various IRS and Department of Labor (DOL) rules and regulations.
In addition, the employer may have to deal with state and local income tax withholding, pay state unemployment and workers’ compensation taxes, and comply with even more local rules and regulations. Handling all of this red tape can cost a bundle every year for each employee. If employee benefits — such as health insurance, paid vacations, and sick leave — are also provided, the cost of keeping a common-law employee on the payroll can become prohibitive.
In contrast, when a worker is properly classified as an independent contractor, the employer must simply provide the worker and the IRS with a Form 1099-MISC each year to report how much the worker was paid. That’s why many businesses prefer to treat as many workers as possible as independent contractors instead of employees.
It’s important to properly set up employment status from the get-go to avoid government audits, enforcement actions and lawsuits. An experienced tax adviser knows the ins and outs of worker classification and can help employers toe the fine line between employee and independent contractor status for their workers.
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