Employee v. Independent Contractors Are you properly classifying your workers?
Classifying workers as either an employee or independent contractor is a common issue that employers face. Its importance should not be ignored. The way your workers are classified could have implications on which federal and state laws require your compliance4 min read
2. IRS 20 Factor Test
4. Independent Contractor Agreements
In recent years, worker misclassification has become a hot topic for federal and state employment and labor agencies. For instance, in September 2014, the U.S. Department of Labor awarded a total of $10.2 million to 19 different states to fund worker misclassification detection and enforcement activities.
Misclassifying and paying a worker as an independent contractor when the worker should be an employee could cause the employer to incur back taxes, interest, penalties, or fines. An audit is often triggered when a worker, who has been classified as an independent contractor, is terminated and seeks unemployment benefits. Sometimes the inquiry expands from the worker at issue to the business’s entire workforce.
All states have different tests for determining whether a worker is an employee or an independent contractor. And, states may use different tests depending on the purpose of determination (i.e. unemployment or workers’ compensation). However, the common theme seen in every state test considers the amount of control the employer has over the worker.
IRS 20 Factor Test
This article will focus on the IRS 20 Factor Test since it is a common test and the most extensive. The IRS test is designed to evaluate who controls how work is performed. Under IRS rules and common-law doctrine, independent contractors control the manner and means by which contracted services, products, or results are achieved. The more control a company exercises over how, when, where, and by whom work is performed, the more likely the workers are employees, not independent contractors.
A worker does not have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker's status. The individual circumstances of each case determine the weight IRS assigns different factors.
Employers uncertain about how to classify a worker can request an IRS determination by filing Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” However, the IRS usually classifies workers as employees whenever their status is not clear-cut and employers that request an IRS determination lose certain protections against liability for misclassification. It is advisable to consult with counsel before submitting an SS-8.
The 20 factors used to evaluate right to control and the validity of independent contractor classifications include:
- Level of instruction. If the company directs when, where, and how work is done, this control indicates a possible employment relationship.
- Amount of training. Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished.
- Degree of business integration. Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.
- The extent of personal services. Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.
- Control of assistants. If a company hires, supervises, and pays a worker's assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship.
- Continuity of relationship. A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.
- The flexibility of the schedule. People whose hours or days of work are dictated by a company are apt to qualify as its employees.
- Demands for full-time work. Full-time work gives a company control over most of a person's time, which supports a finding of an employment relationship.
- Need for on-site services. Requiring someone to work on company premises— particularly if the work can be performed elsewhere—indicates a possible employment relationship.
- The sequence of work. If a company requires work to be performed in specific order or sequence, this control suggests an employment relationship.
- Requirements for reports. If a worker regularly must provide written or oral reports on the status of a project, this arrangement indicates a possible employment relationship.
- Method of payment. Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.
- Payment of business or travel expenses. Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.
- Provision of tools and materials. Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.
- Investment in facilities. Independent contractors typically invest in and maintain their work facilities. In contrast, most employees rely on their employer to provide work facilities.
- Realization of profit or loss. Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.
- Work for multiple companies. People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
- Availability to the public. If a worker regularly makes services available to the general public, this supports an independent contractor determination.
- Control over-discharge. A company's unilateral right to discharge a worker suggests an employment relationship. In contrast, a company's ability to terminate independent contractor relationships generally depends on contract terms.
- Right of termination. Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.
Independent Contractor Agreements
Businesses often think that signing an independent contractor agreement with their workers is enough. While it is important for all your independent contractors to sign these agreements before working with your company, this alone will not save a business from worker classification issues. A court or government agency will still consider the level of control the business has over the worker and whether the relationship passes the applicable worker classification test.
If you are a business owner considering hiring independent contractors or if you already engage independent contractors, you need to evaluate the structure of your company’s relationship with the worker. It is advisable to do a self-assessment before any agency conducts an independent inquiry. Be proactive and stop the problem before it starts!