Independent Contractor or Employee, That Is the Question (and the IRS Has An Answer)
Being a small business owner with employees is tough. Fighting through a myriad of employment laws – the Americans With Disabilities Act , the Fair Labor Standards Act , the Family and Medical Leave Act , and the list goes on and on. Then there are the employment-related benefits – 401(k), pensions and health insurance. To top it off, you also have to worry about withholding taxes .
For some business owners, fighting through this morass is daunting enough to consider using independent contractors instead of employees. With independent contractors, there are no withholding taxes (and the compensation paid to an independent contractor is reported on Form 1099 rather than a W-2), no employee benefits to speak of, and most of the employment-related laws do not apply.
Sounds easy, right? Forget about having employees; just make everyone independent contractors and problem solved, right? Not quite. Determining whether someone is an independent contractor or an employee is not a decision to be made unilaterally by a business owner. Instead, the Internal Revenue Service (IRS) has created a 20 factor test to determine on what side of the line an individual worker falls.
This test, also called the “right-to-control test” (because each factor is designed to evaluate who controls how work is performed). Note that a worker does not have to meet all 20 factors to qualify as an employee or independent contractor, and no single factor is dispositive. Rather, the individual circumstances of each case determine the weight the IRS assigns different factors.
So now, without further ado, here are the IRS’ 20 factors:
1. Instructions. Workers who must comply with your instructions as to when, where, and how they work are more likely to be employees than independent contractors.
2. Training. The more training your workers receive from you, the more likely it is that they’re employees. The underlying concept here is that independent contractors are supposed to know how to do their work and, thus, shouldn’t require training from the purchasers of their services.
3. Integration. The more important that your workers’ services are to your business’s success or continuation, the more likely it is that they’re employees.
4. Services Rendered Personally. Workers who must personally perform the services for which you’re paying are more likely employees. In contrast, independent contractors usually have the right to substitute other people’s services for their own in fulfilling their contracts.
5. Hiring Assistants. Workers who are not in charge of hiring, supervising, and paying their own assistants are more likely employees.
6. Continuing Relationship. Workers who perform work for you for significant periods of time or at recurring intervals are more likely employees.
7. Set Hours of Work. Workers for whom you establish set hours of work are more likely employees. In contrast, independent contractors generally can set their own work hours.
8. Full Time Required. Workers whom you require to work or be available full time are likely to be employees. In contrast, independent contractors generally can work whenever and for whomever they choose.
9. Work Done on Premises. Workers who work at your premises or at a place you designate are more likely employees. In contrast, independent contractors usually have their own place of business where they can do their work for you.
10. Order or Sequence Set. Workers for whom you set the order or sequence in which they perform their services are more likely employees.
11. Reports. Workers whom you require to submit regular reports are more likely employees.
12. Payment Method. Workers whom you pay by the hour, week, or month are more likely employees. In contrast, independent contractors are usually paid by the job.
13. Expenses. Workers whose business and travel expenses you pay are more likely employees. In contrast, independent contractors are usually expected to cover their own overhead expenses.
14. Tools and Materials. Workers whose tools, materials, and other equipment you furnish are more likely employees.
15. Investment. The greater your workers’ investment in the facilities and equipment they use in performing their services, the more likely it is that they’re independent contractors.
16. Profit or Loss. The greater the risk that your workers can either make a profit or suffer a loss in rendering their services, the more likely it is that they’re independent contractors.
17. Works for More Than One Person at a Time. The more businesses for which your workers perform services at the same time, the more likely it is that they’re independent contractors.
18. Services Available to General Public. Workers who hold their services out to the general public (for example, through business cards, advertisements, and other promotional items) are more likely independent contractors.
19. Right to Fire. Workers whom you can fire at any time are more likely employees. In contrast, your right to terminate an independent contractor is generally limited by specific contractual terms.
20. Right to Quit. Workers who can quit at any time without incurring any liability to you are more likely employees. In contrast, independent contractors generally can’t walk away in the middle of a project without running the risk of being held financially accountable for their failure to complete the project.
The IRS test is not the sole means of determining workers’ status. For example, Minnesota law provides that, in regards to the building construction industry, if a subcontractor is an individual rather than an LLC, corporation or partnership, and if that subcontractor does not apply for and receive an “independent contractor exemption certificate” , then that worker is deemed to be an employee of the general contractor who will be responsible for the payment of withholding taxes and payment of workers compensation premiums.
The IRS continues to pay close attention to worker classification in order to find improper classifications that are designed to deny funds otherwise headed to the Treasury. Hence, proper classifications are essential to the life and health of your business, and proper consultation with your tax professional as well as your employment counsel is a must.