Independent contractor or employee:
Can your business pass the test?
those workers as independent contractors instead of as employees
seemed like a good idea at the time. But can they pass the test
-- the IRS test? It takes more than a written contract to designate
a worker as an independent contractor.
This tax tip explains that, in
general, the degree of control you exercise over the worker determines
whether the worker is an employee or independent contractor. Learn
the 20 tests for determining whether yours is an employer-employee
relationship in the eyes of the IRS.
We also point out the "red flags" that attract
IRS scrutiny. Find out what you can do to put the issue of classification
to rest once and for all.
is in control?
When determining whether someone is an independent contractor or
an employee, consider the worker's relationship to your business
-- that's what the IRS is going to do. According to IRS Publication
15A: Employer's Supplemental Tax Guide, proof of the status of the
employee falls into three categories:
- Behavioral control -- Does the business
provide the worker with
- Instructions? An employee generally relies
on a business's instructions about when, where and how to
- Training? An employee receives specific
training, while independent contractors use their own methods.
- Financial control -- What is the extent
of the worker's
- Unreimbursed business expenses? Independent
contractors are more likely to have unreimbursed expenses.
- Investment? An independent contractor
often has a significant investment in the facilities used
in performing services for someone else.
- Availability to the relevant market?
If a worker performs services for several firms at the same
time, that factor generally indicates that the worker is an
- Pay structure? Employees receive payments
at designated times. An independent contractor is usually
paid by the job.
- Ability to realize a profit or loss?
An independent contractor can make a profit or take a loss.
- Type of relationship --
- Does the business provides the worker
with employee-type benefits, such as insurance, a pension
plan, vacation pay or sick pay?
- Is there a written contract that describes
the relationship the parties intended to create?
- How permanent is the relationship?
- How crucial is the worker's activity
to the regular business of the company?
What's the bottom line? According to Howard
Simon, a partner in the labor, employment and benefits law group
of Landels, Ripley & Diamond LLP in San Francisco, hiring an
independent contractor implies you are purchasing a product, an
outcome. "To the extent you retain the right to control the means
by which that's done, (the worker) looks more and more like an employee,"
play 20 questions
How does the IRS resolve the right-to-control issue? According
to The Independent Contractor Report, they test 20 factors in your
Employees are workers who are required to comply with another person's
instructions about when, where and how they are to work; specifically,
if the person for whom the services are performed has the RIGHT
to require compliance with instructions.
Training implies a worker is an employee. Training a worker occurs
by requiring an experienced employee to work with the worker, by
corresponding with the worker, by requiring the worker to attend
meetings or by using other methods.
To what degree are the worker's services merged into the business
operations? Evidence of direction and control is confirmed by how
much the continuation of a business depends upon the performance
of certain services.
4. SERVICES RENDERED
Requiring that the services be rendered personally indicates that
the person for whom the services are performed is interested in
the methods used to accomplish the work, as well as in the results.
5. HIRING, SUPERVISING
AND PAYING ASSISTANTS
When a business owner hires a worker and then hires assistants for
the worker, there is an implied employer-employee relationship between
the owner and the worker. If the worker hires his own assistants
in order to fulfill a contract with the business owner, the implication
is that the worker is a contract worker.
6. CONTINUING RELATIONSHIP
An employer-employee relationship exists if there is a continuing
relationship between the worker and the business owner, even if
work is performed at irregular intervals.
7. SET HOURS OF WORK
Control is confirmed if the business owner establishes set hours
of work control.
8. FULL TIME REQUIRED
An independent contractor is free to work when and for whom he chooses.
If the worker dedicates a full-time schedule to the business owner,
this implies the worker is restricted from doing other gainful work.
9. DOING WORK ON EMPLOYER'S
Control over the worker may be indicated if the work is performed
on the premises of the business owner, especially if the work could
be done elsewhere. While having an office off the premises indicates
some freedom from control, this fact by itself doesn't mean that
the worker isn't an employee. If the business owner has the right
to compel the worker to travel a designated route, to canvass a
territory within a certain time or to work at specific places as
required, control is confirmed.
10. ORDER OR SEQUENCE
Control is suggested if a worker must perform services in the order
set by the business owner.
11. ORAL OR WRITTEN
Requiring workers to submit regular or written reports to the business
owner indicates control.
12. PAYMENT BY HOUR,
An employer-employee relationship is suggested when the worker is
paid by the hour, week or month. Payment made by the job or on straight
commission generally indicates that the worker is an independent
13. PAYMENT OF BUSINESS
AND/OR TRAVELING EXPENSES
If the business owner pays the worker's business and traveling expenses,
the worker is an employee.
14. FURNISHING OF TOOLS
If the business owner furnishes tools, materials and other equipment,
this implies an employer-employee relationship.
15. SIGNIFICANT INVESTMENT
If the worker invests in facilities he uses for performing services,
this tends to indicate that the worker is an independent contractor.
16. REALIZATION OF
PROFIT OR LOSS
If a worker can realize a profit or suffer a loss from services
provided, he is generally an independent contractor. A worker who
can't is an employee.
17. WORKING FOR MORE
THAN ONE FIRM AT A TIME
If a worker performs services for several unrelated persons or firms
at the same time, that factor generally indicates that the worker
is an independent contractor.
18. MAKING SERVICE
AVAILABLE TO GENERAL PUBLIC
Making services available to the general public on a regular and
consistent basis indicates an independent contractor relationship.
19. RIGHT TO DISCHARGE
The right to discharge a worker indicates that the worker is an
employee and the person with this right is an employer. An independent
contractor can't be fired if they meet the contract specifications.
20. RIGHT TO TERMINATE
If the worker has the right to end his relationship with the business
owner at any time without incurring liability, that factor indicates
an employer-employee relationship.
As you can see, a written agreement is among
the 20 factors used, but it isn't the last line of defense. To make
matters more confusing, the IRS doesn't consider these factors equally.
A review of The Independent Contractor Report also suggests that
these factors are subject to interpretation by relevant court cases.
So how do you stay out of trouble? Simon repeats
that the key issue is control. "To the extent that you, as the hiring
person, tell the person where to be and when to be there, require
weekly reports, provide training, control the assistants ... you're
exercising control over the means. The more control you have over
the means, the more you look like an employer."
While IRS interpretation of the issues isn't always clear-cut,
there are at least two red flags.
The first is inconsistent treatment. Businesses
under the gun to meet a deadline might hire independent contractors
to help in-house employees complete a job. While hiring on a temporary
basis appears to justify the classification, you have a problem.
You already have someone in-house on a W-2 basis performing the
As Simon puts it, "If you've got two people
doing the same work functionally but you're calling them different
things, that's vulnerable." He suggests using a temp agency to safeguard
against this situation. You address the employee-independent contractor
issue, and the IRS gets the income tax withholding.
The other big red flag is how central a particular
service is to what your business actually does. If the service is
closely related to your business's central function, you're a prime
target for an audit.
The way the IRS sees it, a business isn't likely
to contract out an underlying service. An accounting firm won't
hire just anyone to fill an accountant position. Using an independent
contractor to landscape the grounds is less likely to subject the
firm to scrutiny.
The prospect of going one-on-one with the IRS
over employee classifications may be daunting. New business owners
in particular may be overwhelmed by the thought of wading through
this issue on their own.
If you want to avoid problems with the IRS once
and for all, visit the IRS Web
site or call the IRS at 1-800-TAX-FORM and request:
- IRS Publication 937: Business Reporting
- Form SS-8, Information for Use in Determining
Whether a Worker is an Employee for Federal Employment Taxes and
Income Tax Withholding
The SS-8 allows workers and employers to receive
an IRS Private Letter Ruling on the status of the workers. You should
seek professional advice before submitting this form. Greta Hicks,
a CPA at Uncle Fed's tax site, cautions against taking these questions
lightly, warning "the questions are worded in such a way that all
workers are employers." She strongly urges businesses and workers
to obtain a copy of the SS-8.
-- Posted: July 1, 1999