Employee v. Independent Contractor Considerations
The Internal Revenue Service (“IRS”) provides guidance in order to assist employers in classifying workers as an employees versus independent contractors. The proper classification helps employers determine whether they are required to withhold Federal and if applicable, state, and local income taxes; Federal Insurance Contributions Act (“FICA”) tax; Federal Unemployment Tax Act (“FUTA”) tax and additional federal or state required taxes.
Considerations In Determining Status
As noted by the IRS, when making the determination as to whether a worker providing services is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
- Behavioral Control: Does the company control or have the right to control what the individual does and how the individual does his or her job?
- Financial Control: Are the business aspects of the individual’s job controlled by the payer? (these include things like how individual is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Relationship of the parties: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Over what term will the relationship continue and is the work performed a key aspect of the business?
Behavioral Control
Behavioral control refers to facts and circumstances as to whether there is a right to direct or control how the individual performs the work. An individual is generally considered an employee when the business has the right to direct and control the individual. The business does not have to actually direct or control the way the work is performed – as long as the employer has the right to direct and control the work.
Financial Control
Financial control refers to those facts that demonstrate whether or not the business has the right to control the economic aspects of the individual’s job. When taking into account the various factors determined as to financial control the following are considerations:
- Significant investment – It is commonplace for an independent contractor to have made a significant investment in the equipment he or she uses in performing work for a third party.
- Unreimbursed expenses – Often times independent contractors incur expenses in performing work for a third party that are not reimbursable expenses.
- Opportunity for profit or loss – The opportunity to yield a net profit or loss from performing work for a third party. In making this determination it is important to note if the compensation arrangement is such that the individual is personally responsible for all costs incurred in performing the function for a set fee no matter the costs incurred to complete the task.
- Services available to the market – An independent contractor is generally free to seek out other business opportunities whilst performing work engagements. Independent contractors have the ability to advertise, maintain a visible business location, and are available to work in the relevant market.
- Method of payment – In an employment arrangement, individuals are compensated at regular intervals, hourly, weekly, monthly, etc. This type of arrangement generally connotates that the individual is an employee, even when the wage or salary is supplemented by a commission. Arrangements with independent contractors are generally such that a determined amount is to be paid for the services performed; although it is common in some professions, to compensate independent contractors at an agreed upon hourly rate. Additionally, independent contractors will submit an invoice for payment at agreed upon intervals for payment of services rendered.
Relationship of the Parties
Type of relationship refers to facts that show how the individual and business perceive their relationship with each other. The factors, for the type of relationship between two parties, generally fall into the categories of:
- Written Contracts – Although a contract between the parties may delineate whether the individual is an employee or an independent contractor, this alone is insufficient to determine the individual’s status. The IRS is not required to follow a contract stating that the individual is an independent contractor, responsible for paying his or her own self-employment tax. The facts and circumstances as to the arrangements governing how the parties work together determine whether the individual is an employee or an independent contractor.
- Employee Benefits – Employee benefits include items such as insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors, however, the lack of these types of benefits does not necessarily mean the individual is an independent contractor.
- Permanency of the Relationship – If an organization hires an individual with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
- Services Provided as Key Activity of the Business – If an individual provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a CPA firm hires a CPA, it is likely that it will present the CPA’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship
IRS 20 Factor Checklist
The IRS has also provided a 20 factor checklist for reference when determining whether a worker should be considered an employee or an independent contractor. These 20 factors include, but are not limited to, the following:
- Must the individual take instructions from your management staff regarding when, where, and how work is to be done?
- Is there a continuing relationship between your company and the individual?
- Must the individual work set hours?
- Is the individual required to work full time at your company?
- Must the individual give you reports regarding his/her work?
- Is the individual paid by the hour, week, or month?
- Does the individual only perform services for your company?
Conclusion
An organization should review the above IRS individual classification rules to ensure that they correctly identify and accordingly account for an individual as either an employee or independent contractor. As in the past, the IRS continues to highlight correct employer classification of individuals as one of its key initiatives. As noted by the IRS on its website, “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.”
It is important to note that if an individual is determined to be an independent contractor with no reasonable basis for doing so, the deemed “employer” may be held liable for employment taxes for that individual. The proper classification of individuals can save employers from facing difficulties, confusion and possible fines in the future.
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.