As our economic woes continue and companies cut costs, laid-off workers are increasingly added to the unemployment rolls. Those workers are likely to take jobs as independent contractors because they will take the work they can get and because companies sometimes cut too deep and now need help. And that is where the increased jeopardy to employers can occur: in properly classifying independent contractors for tax purposes. The classification can be tricky. For example, the distinction between an employee and an independent contractor can be blurry. If an employment relationship contains too many “employee” characteristics, the relationship is vulnerable to reclassification by the IRS as an employer-employee relationship.
It’s important that an organization retaining the services of independent contractors develop a formal policy and procedure for determining whether an individual worker is an independent contractor. Companies need an evaluation process, required documentation and procedures to strengthen the independence classification. It can be a complex process.
For example, the IRS, which has expressed general antipathy toward the use of independent contractors, has established a twenty factor test for determining whether an individual is an employee or an independent contractor. The 20 factors identified by the IRS focus in large part on whether sufficient control is present to establish an employer-employee relationship. An employer-employee relationship exists if the person for whom the services are performed has the right to control and direct the individual performing the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished.
The 20 factors set forth by the IRS (in no particular order) are as follows:
- Services rendered personally. A worker who is required to render services personally evidences employee status.
- Training. The more training a worker receives, the more likely that the worker is an employee.
- Set hours of work. The fact that a worker is required to perform services during set hours is evidence of employee status.
- Instructions. A requirement that the worker must follow instructions concerning when, where, and how to perform his or her work, is evidence of control and indicative of employee status.
- Hiring, supervising, and paying assistants. If a service recipient hires, supervises, and pays the worker’s assistants, this is evidence of employee status. Moreover, a worker who hires, supervises and pays assistants may nevertheless be considered an employee, if such actions are at the direction and on behalf of the service recipient.
- Integration. Integration focuses on the extent to which the services provided by the worker are necessary to, and meld into, the overall business operations of the service recipient. The fact that a worker’s services are highly integrated into the recipient’s business is indicative of employee status.
- Continuing relationship. A continuing relationship between the worker and the service recipient is evidence of an employer-employee relationship. Both the regularity and duration of the relationship are taken into consideration for purposes of this factor.
- Full-time required. If the worker is required to devote his or her full time to a specific service recipient, this is evidence of employee status. Full time does not necessarily require eight-hour days or a specific work week, but rather varies with the nature of the specific occupation and local customs.
- Doing work on employer’s premises. Use of the service recipient’s premises and office equipment can be evidence of employee status. To the extent the services could be performed elsewhere, the inference of control becomes weaker.
- Order of sequence set. If a worker is required to perform tasks in a set way and must follow set routines and schedules, the worker resembles an employee.
- Oral or written reports. The fact that a worker is required to submit regular reports to the service recipient is indicative of employee status.
- Payment by hour, week, or month. A worker being paid at regular intervals is evidence of employee status.
- Payment of business and/or traveling expenses. If a worker’s expenses are paid or reimbursed by the service recipient, this is evidence that the worker is an employee.
- Furnishing of tools and materials. The fact that a worker is furnished tools and materials is evidence that the worker resembles an employee.
- Significant investment. If a worker does not invest in the facilities and/or equipment used in the performance of service, this is evidence of employee status.
- Realization of profit or loss. A worker who is compensated for his or her services at a fixed rate, regardless of the profitability of the services performed, evidences employee status.
- Working for more than one firm at a time. A worker who performs services for only one firm at a time is indicative of employee status.
- Making services available to the general public. If services are not offered to the general public, the worker resembles an employee.
- Right to discharge. A worker who can be discharged at any time is usually perceived to be an employee. An independent contractor can be discharged only for failure to comply with the terms of his or her contract.
- Right to terminate. A worker who may terminate his or her relationship with the service recipient at any time evidences employee status. An independent contractor may terminate his or her relationship only upon completion of the contract or breach of the contract by the other party.
In addition to federal classification, many states adopt the so-called “ABC test” for classifying workers as independent contractors or employees. This test is often interpreted or applied in a broader manner than the twenty factor common law test used at the federal level and can result in a worker being classified as an employee for state unemployment tax purposes, but as an independent contractor for the federal payroll tax.
Under the ABC test, any service for remuneration is employment unless it is shown that:
- The worker is free from control or direction in the performance of his or her work under contract and in fact; and
- The service is either outside the usual course of the business for which such service is performed, or it is performed outside of all the places of business of the enterprise for which such service is performed; and
- The worker is customarily engaged in an independently established trade, occupation, profession, or business.
Clearly, using a contractor may cut down on personnel costs and allow a worker to perform services of a temporary nature, but ultimately if the worker is misclassified and should have been on the payroll, the costs after an audit may far exceed the savings of using the contractor. Companies could face potential assessment of federal and state payroll taxes, penalties, interest, wage and hour issues with the Department of Labor and issues surrounding the reporting of fringe benefits.
The best policy is to seek help in reviewing a company's hiring policies and use of contractors to ensure that proper screening and procedures are in place. And if an audit does occur, they should seek professional representation in order to minimize any assessment.
This article contributed by Mindy Harada.