How Does the IRS Determine Employee or Independent Contractor Status?

By Kendra Schlautman

Knowing how to classify a worker as an employee or as an independent contractor is a question that we receive from many business owners. While we like to serve our clients by providing clear and succinct advice, there is unfortunately no one standard or factor for making this determination.

In general, an independent contractor is a worker who is:

  1. Not covered by employment, labor and other related tax laws, and
  2. Does not have employment taxes withheld from the payments they receive from the business for the work they perform.

Based on the two scenarios above, many business owners may be persuaded to classify a worker as an independent contractor. However, incorrect worker classification can be a significant risk, often leaving the business responsible for repaying years of taxes that were not adequately withheld, as well as penalties and interest. Additionally, because applicable taxes were left to be paid by the independent contractor, the business owner is generally left paying a higher fee to cover the cost that was passed on to the independent contractor.

In determining proper employee versus independent contractor classification, the IRS looks at the nature of the relationship between the business and the worker. Specifically, the degree of control or independence the owner has of the worker, which can fall into the following three categories.

  1. Behavioral control applies to whether the business can control how work is done through training or instructions. Generally, employees are given directions on when and where to work, what tools to use, and what orders to follow.
  2.  Financial control applies to the extent of the worker’s unreimbursed business expenses, investment in the resources used, ability to make services accessible to the relevant market, and ability to realize a gain or loss from the business. Normally, an independent contractor provides his own tools or equipment, can make his services accessible to the general public, and is at risk of incurring a gain or loss in the business.
  3. Type of relationship applies to whether there is a written contract expressing the relationship between the business and the worker, the business provides employee benefits, there is access for the worker to perform work for similar businesses, and the worker is a key aspect of regular business. Commonly, employees receive employment benefits (such as insurance or vacation pay), only work for one business at a specific time, and work for the business on a regular basis. Independent contractors generally can work for several businesses at one time and the relationship between the business and the worker will end once the work is complete.

This three-category method is a condensed version of the 20-factor test previously used by the IRS. The 20-factor test includes other items, such as setting hours of work, working on employer premises, firm’s right to discharge worker, and worker’s right to terminate relationship, just to name a few. Examples of a few items from the 20-factor test include:

Employees

  • Usually have set work hours
  • Work on the employer’s premise
  • Can be fired
  • Have the right to terminate the employment relationship
  • Receive a net paycheck after withholding and payroll taxes

Independent contractors

  • Generally don’t have set work hours
  • Often work away from the employer’s premise
  • Cannot be discharged by the business or terminate the relationship with the business due to contractual agreement
  • Receive payment for their gross invoice amount just like any other vendor

For further information on the classification of employee versus independent contractor, including the full 20-factor test, please contact our office.

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