It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors.
Generally, you must withhold and deposit income taxes, social security taxes and Medicare taxes from the wages paid to an employee. Additionally, you must also pay the matching employer portion of social security and Medicare taxes as well as pay unemployment tax on wages paid to an employee. Generally, you do not have to withhold or pay any taxes on payments to independent contractors.
The determination of whether a worker should be treated as an employee or independent contractor has been difficult at best, compounded by the myriad tests used by courts and federal and state agencies. With the growing trend of workers working remotely, an argument can be made that the classification of remote workers as independent contractors will become more common and supportable.
The IRS Test
The IRS has its own test for determining a worker’s status. It is the common-law test that replaced the 20-factor test previously used. This test consists of three factors to determine worker status: behavioral control, financial control, and relationship type.
A. Behavioral Control
This factor looks at whether there is a right to direct or control how the worker does the work. Two key elements apply to the behavioral control factor: the type and degree of instructions given and the degree of training provided. If an employer gives instructions on when, where, and how work must be performed, then most likely employee status will be determined. The more detailed the instructions on what work must be done and how, the more likely the worker will be classified as an employee. Instructions regarding what tools and equipment should be used and where to purchase them, the hiring of assistants to help perform the work, and the sequence of tasks to be performed are also indicative of employee status. “The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.” For the second consideration, if the employer provides training to its workers, then most likely employee status will be found. Training is directed to ensure that employees perform the job’s tasks in a specific manner as directed by the employer. The same cannot be said about independent contractors who use their own routines to complete assigned tasks.
B. Financial Control
This factor refers to whether the employer has the right to control the economic aspects of the worker’s job. It has five elements: significant investment, unreimbursed expenses, opportunity for profit or loss, services available to the market, and method of payment. Although significant investment does not play a major role in determining worker status, it still needs to be taken into account when looking at what tools and equipment a worker is given to do the job. Unreimbursed expenses are something that independent contractors may claim more than an employee. However, it is still possible that employees will have this type of expense depending on what is needed to perform the job. Opportunity for profit or loss is another element that signifies independent contractor status. This entails whether a worker runs the risk of losing money while performing the job and whether expenses could exceed the income from the job. Services available to the market suggest independent contractor status in that workers are free to advertise their skills, maintain a business location, and are available to work anywhere based on market needs. Lastly, the method of payment is an element in determining worker status. An employee is compensated by a regular salary for the time spent performing the job whether it be hourly, weekly, or other time-based pay. Conversely, an independent contractor is generally paid a set fee for services rendered or the performance of a specific job.
C. Relationship Type
This factor refers to how the worker and employer perceive their relationship to each other and includes four elements: written contracts, employee benefits, permanency of the relationship, and services provided as key activities of the business. A written contract cannot alone determine worker status although it is evidence of how the parties view the relationship. Employee benefits such as insurance, paid time off, and pension plans are usually given to employees. Although not impossible, it is less likely that independent contractors will be given the same benefits. Permanency of the relationship refers to whether the person who hires a worker expects that relationship to go on for an unlimited time (employee) rather than for one specific job (independent contractor). Lastly, services provided as part of a key activity of the employer’s business suggest employee status.
Two cases considered the three-pronged behavioral control, financial control, and relationship type standard articulated in IRS guidelines and reached the same conclusion. In the Lytle case, a district court considered whether drivers for a transportation company were employees or independent contractors. At the outset, the court noted that the guidelines were similar to the common-law agency test, and applying either standard would produce the same result. While the employer specified some of the details of how the workers performed their jobs, it did not control their businesses. The workers owned their vans and were responsible for maintaining and insuring them. They were also responsible for their own taxes, for hiring and firing their own drivers, and for paying their drivers.21 They controlled the scheduling and timing of their routes and could reject routes that they thought were unprofitable. The court determined that the workers were not employees. Similarly, in the Images in Motion of El Paso case, the Tax Court reversed the findings of the IRS and concluded that the employer had a reasonable basis for treating the instructors at its dance studio as independent contractors. While there was an instructors’ manual, it was little more than a guideline and did not control the instructors’ performance of their jobs. They selected the classes they wanted to teach based on their individual talents and experience. The employer did not provide the instructors with any training — they brought their own expertise to the relationship with the employer. Further, the instructors had a large financial stake in their dance activities and purchased their own costumes and music. The relationships created by the employer and its instructors were not permanent; if an instructor did not sign up to teach another session, the working relationship between that instructor and the employer ended.
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship and consider the extent of the right to direct and control the worker. Finally, document each of the factors used in coming up with the determination.
