How the IRS Determines Independent Contractor Status

How the IRS Determines Independent Contractor Status

Workers are not necessarily employees, at least in a legal and tax sense. If you hire people to perform functions for your company, the IRS could consider them as either employees or independent contractors.

The difference is critical – to you and to the IRS. In general terms, employers do not have to pay payroll taxes and Social Security, provide benefits, pay unemployment or disability insurance, etc. for independent contractors. If you require short-term or infrequent specialized skills, independent contractors can be the perfect solution… but run afoul of IRS regulations and the penalties can be significant (as you'll see.)

How do we determine if an individual is an employee or Independent Contractor? The IRS focuses on three basic tests:

  • Behavior
  • Financial
  • Relationship

Let's look at each.

Behavioral

As the employer, do you have direct control and the authority to control the ways and means the worker carries out work functions? If so, the worker is most likely an employee rather than an independent contractor.

The key is the level of instruction you as the "employer" gives to the worker. The more defined and complete those instructions, the more likely the worker should be classified as an employee.

Think of it this way: if you hire an independent contractor, typically you explain the project and leave the details of how to carry out completing the project to the worker. Do you provide training to the worker? Employees are typically trained; independent contractors follow their own methods.

Instructions might include:

  • When, where, and how to perform work
  • Tools or equipment to use
  • Where and how to purchase supplies and services
  • What order or sequence to follow in completing tasks or processes

Keep in mind that even if you provide no instructions, if you have the right to control how the work is performed, the worker may still be an employee. The critical point is whether you as an employer retain the right – even if you choose not to exercise that right – to control the ways and means a worker carries out essential job functions.

Financial

As an employer, do you have direct control over business aspects of the worker's duties? Do you control how the worker is paid? Do you reimburse for expenses? Do you provide tools, supplies, and other commodities? If so, the worker is typically classified as an employee.

Other factors:

  • Does the worker incur fixed costs whether or not work is currently performed? If so, the worker is an independent contractor.
  • Has the worker made significant investment in the facilities or tools used to perform the work required? If yes, then the worker is classified as an independent contractor. (That may not be the case in certain industries, however; for example, automobile mechanics and construction workers are often required to furnish their own tools but are still classified as employees.)
  • Does the worker provide services to other businesses? If so, the worker is almost always classified as an independent contractor, especially if they advertise those services and maintain a separate business location.
  • Is the worker paid regular, ongoing wages? Employees are typically guaranteed a regular wage amount for established work periods. Independent contractors are typically paid by the job or by the hour on a contract basis.
  • Can the worker make a profit or suffer a loss on the work performed? If so, the worker is an independent contractor. Employees are simply paid; they do not enjoy profits or suffer losses.

Relationship

What is the legal relationship between you and the worker? Do you have a written contract in place describing your business relationship? Do you provide employee benefits like insurance, pension plans, vacation pay and sick pay? If so, your relationship classifies the worker as an employee.

Another key test is permanency: If the worker expects the relationship to only last for a specific project or defined time period, the worker is typically classified as an independent contractor. Keep in mind permanency can be overridden by other factors; you may decide to engage an independent contractor in ongoing work that lasts for years – but if the worker meets other tests to qualify for independent contractor status, the duration of the relationship will not create an employer/employee relationship. For example, if you hire a service person to maintain equipment at your facility, and that person performs that work for five years, as long as the Financial and Behavioral tests signify the worker is an independent contractor, the length of the business relationship is irrelevant.

Keep in mind the IRS uses the above tests to determine if a worker is an independent contractor or employee, even if other agreements are in place. For example, if you have the worker sign an agreement stating he or she is an independent contractor and not an employee, it may not be sufficient to legally establish independent contractor status. The IRS looks at the facts, not a written agreement, to determine the actual work relationship.

So what happens if you classify a worker incorrectly?

The Impact of Misclassification

Whether or not you deliberately misclassified a worker, the consequences are the same. Not only can you face penalties, you may be liable for damages like paying judgments for wages owed, back taxes, past medical expenses (if the worker was injured on the job), and other benefits not provided.

Making the Relationship Work

Contracting services by engaging independent contractors is often a smart move; you can hire the skills you need without incurring the expense of hiring and maintaining full-time employees. The key to avoiding legal or tax problems is to create the business relationship between yourself and another company – not between yourself and the individual worker.

When you do, the worker's employer (even if the worker is self-employed) is responsible for payroll and benefits administration. Then be sure the responsibilities are spelled out: The worker is given responsibility for directing and controlling work functions, training, creating work rules, etc. In almost every case, a written contract – or even a purchase order – fully describing the rights and responsibilities of each party will go a long way towards protecting you from the legal hassles and expense of misclassifying a worker.

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