Classifying those workers as independent contractors instead of as employees seemed like a good idea at the time. But can they pass the test - the IRS test? It takes more than a written contract to designate a worker as an independent contractor.
The following explains that, in general, the degree of control you exercise over the worker determines whether the worker is an employee or independent contractor. Learn the 20 questions test for determining whether yours is an employer-employee relationship in the eyes of the IRS.
Also pointed out are "red flags" that attract IRS scrutiny.
Find out what you can do to put the issue of classification to rest once and for all.
Who is in control?
When determining whether someone is an independent contractor or an employee, consider the worker's relationship to your business -- that's what the IRS is going to do. According to IRS Publication 15A: Employer's Supplemental Tax Guide, proof of the status of the employee falls into three categories:
Behavioral control -- Does the business provide the worker with
Instructions? An employee generally relies on a business's instructions about when, where and how to work.
Training? An employee receives specific training, while independent contractors use their own methods.
Financial control -- What is the extent of the worker's
Unreimbursed business expenses? Independent contractors are more likely to have unreimbursed expenses.
Investment? An independent contractor often has a significant investment in the facilities used in performing services for someone else.
Availability to the relevant market? If a worker performs services for several firms at the same time, that factor generally indicates that the worker is an independent contractor.
Pay structure? Employees receive payments at designated times. An independent contractor is usually paid by the job.
Ability to realize a profit or loss? An independent contractor can make a profit or take a loss.
Type of relationship --
Does the business provide the worker with employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay?
Is there a written contract that describes the relationship the parties intended to create?
How permanent is the relationship?
How crucial is the worker's activity to the regular business of the company? What's the bottom line? Hiring an independent contractor implies you are purchasing a product, an outcome. To the extent you retain the right to control the means by which that's done, (the worker) looks more and more like an employee.
How does the IRS resolve the right-to-control issue? According to The Independent Contractor Report, they test 20 factors in your business:
Employees are workers who are required to comply with another person's instructions about when, where and how they are to work; specifically, if the person for whom the services are performed has the RIGHT to require compliance with instructions.
Training implies a worker is an employee. Training a worker occurs by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings or by using other methods.
To what degree are the worker's services merged into the business operations? Evidence of direction and control is confirmed by how much the continuation of a business depends upon the performance of certain services.
SERVICES RENDERED PERSONALLY
Requiring that the services be rendered personally indicates that the person for whom the services are performed is interested in the methods used to accomplish the work, as well as in the results.
HIRING, SUPERVISING AND PAYING ASSISTANTS
When a business owner hires a worker and then hires assistants for the worker, there is an implied employer-employee relationship between the owner and the worker. If the worker hires his own assistants in order to fulfill a contract with the business owner, the implication is that the worker is a contract worker.
An employer-employee relationship exists if there is a continuing relationship between the worker and the business owner, even if work is performed at irregular intervals.
SET HOURS OF WORK
Control is confirmed if the business owner establishes set hours of work control.
FULL TIME REQUIRED
An independent contractor is free to work when and for whom he chooses. If the worker dedicates a full-time schedule to the business owner, this implies the worker is restricted from doing other gainful work.
DOING WORK ON EMPLOYER'S PREMISES
Control over the worker may be indicated if the work is performed on the premises of the business owner, especially if the work could be done elsewhere. While having an office off the premises indicates some freedom from control, this fact by itself doesn't mean that the owner isn't an employee. If the business owner has the right to compel the worker to travel a designated route, to canvass a territory within a certain time or to work at specific places as required, control is confirmed.
ORDER OR SEQUENCE SET
Control is suggested if a worker must perform services in the order set by the business owner.
ORAL OR WRITTEN REPORTS
Requiring workers to submit regular or written reports to the business owner indicates control.
PAYMENT BY HOUR, WEEK, MONTH
An employer-employee relationship is suggested when the worker is paid by the hour, week or month. Payment made by the job or on straight commission generally indicates that the worker is an independent contractor.
PAYMENT OF BUSINESS AND/OR TRAVELING EXPENSES
If the business owner pays the worker's business and traveling expenses, the worker is an employee.
FURNISHING OF TOOLS AND MATERIALS
If the business owner furnishes tools, materials and other equipment, this implies an employer-employee relationship.
If the worker invests in facilities he uses for performing services, this tends to indicate that the worker is an independent contractor.
REALIZATION OF PROFIT OR LOSS
If a worker can realize a profit or suffer a loss from services provided, he is generally an independent contractor. A worker who can't is an employee.
WORKING FOR MORE THAN ONE FIRM AT A TIME
If a worker performs services for several unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor.
MAKING SERVICE AVAILABLE TO GENERAL PUBLIC
Making services available to the general public on a regular and consistent basis indicates an independent contractor relationship.
RIGHT TO DISCHARGE
The right to discharge a worker indicates that the worker is an employee and the person with this right is an employer. An independent contractor can't be fired if they meet the contract specifications.
RIGHT TO TERMINATE
If the worker has the right to end his relationship with the business owner at any time without incurring liability, that factor indicates an employer-employee relationship.
As you can see, a written agreement is among the 20 factors used, but it isn't the last line of defense. To make matters more confusing, the IRS doesn't consider these factors equally. A review of The Independent Contractor Report also suggests that these factors are subject to interpretation by relevant court cases.
So how do you stay out of trouble? The key issue is control -- to the extent that you, as the hiring person, tell the person where to be and when to be there, require weekly reports, provide training, control the assistants … you're exercising control over the means. The more control you have over the means, the more you look like an employer.
While IRS interpretation of the issues isn't always clear-cut, there are at least two red flags.
The first is inconsistent treatment. Businesses under the gun to meet a deadline might hire independent contractors to help in-house employees complete a job. While hiring on a temporary basis appears to justify the classification, you have a problem. You already have someone in-house on a W-2 basis performing the same job.
If you've got two people doing the same work functionally but you're calling them different things, that's vulnerable. Use a temp agency to safeguard against this situation. You address the employee-independent contractor issue, and the IRS gets the income tax withholding.
The other big red flat is how central a particular service is to what your business actually does. If the service is closely related to your business's central function, you're a prime target for an audit.
The way the IRS sees it, a business isn't likely to contract out an underlying service. An accounting firm won't hire just anyone to fill an accountant position. Using an independent contractor to landscape the grounds is less likely to subject the firm to scrutiny.
The prospect of going one-on-one with the IRS over employee classifications may be daunting. New business owners in particular may be overwhelmed by the thought of wading through this issue on their own.
If you want to avoid problems with the IRS once and for all, visit the IRS Web site or call the IRS at 1-800-TAX-FORM and request:
IRS Publication 937: Business Reporting
Form SS-8, Information for Use in Determing Whether a Worker is an Employee for Federal Employment Taxes and Income Tax Withholding
The SS-8 allows workers and employers to receive an IRS Private Letter Ruling on the status of the workers. You should seek professional advice before submitting this form.
Be cautious against taking these questions lightly, "the questions are worded in such a way that all workers are employers."