How the IRS Determines Independent Contractor Status
Independent Contractor Tests by the IRS, the Dept. of Labor, and U.S. States
One of the most common errors businesses make is not having the correct status for a worker. The choices are an employee or independent contractor.
An independent contractor (IC) is someone who is in an independent trade or profession offering services to the general public. An IC is considered to be able to control their own work, not the employer. By contrast, an employee's work is controlled and directed by the employer.
Many businesses classify workers as independent contractors because it's cheaper than hiring employees. These businesses avoid:
- Withholding Social Security and Medicare taxes, and paying a portion of those taxes
- Paying premiums for unemployment insurance and workers compensation
- Adhering to minimum wage, overtime, and other wage laws
- Being subject to employment laws like OSHA, ADA, and equal pay
But misclassifying workers as independent contractors instead of employees can result in big costs, including paying workers amounts owed for FICA taxes (Social Security and Medicare), and heavy fines and penalties.
IRS vs. Dept. of Labor Classification
The IRS separates and classifies workers as independent contractors or employees for employment tax purposes. As noted above, independent contractors are not subject to these taxes and businesses don't have to contribute to these taxes.
The Department of Labor uses a different classification system to determine worker status for purposes of wage and hour laws, including minimum wages, overtime, and child labor laws. Independent contractors are not subject to these laws.
Because the IRS and DOL and states have different worker classification rules, a worker may be classified as an independent contractor under one rule and be classified as an employee under another.
How Does the IRS Determine Worker Status?
The IRS uses common law principles to determine if a worker is an independent contractor or an employee. This IRS review relates to federal employment taxes - federal income tax, FICA taxes for Social Security and Medicare, and federal unemployment taxes.
In the past, a "20 Factor Test" was used to evaluate workers to determine whether they were independent contractors or employees. These factors have been compressed into three general categories for IRS review of the specific situation:
- Behavioral Control,
- Financial Control, and
- Relationship of the Parties.
As you look at the factors below, you should be aware that the IRS does not look specifically at any one factor, but one factor can be enough to cause the IRS to determine that a worker is an employee. There is no "magic number" of factors which determines status.
The IRS presumes that a worker is an employee unless proven otherwise. So the burden of proof is on the employer to show that it has classified a worker correctly.
Factors for Determining Worker Status
The IRS no longer uses this specific 20-question test to determine worker status, but it might help you to understand the details of what is being evaluated.
- Actual instruction or direction of the worker. A worker who is required to comply with instructions about when, where and how to work is ordinarily an employee. The instructions may be in the form of manuals or written procedures that show how the desired result is to be accomplished.
- Training. Training of a worker by an experienced employee working...by correspondence, by required attendance at meetings and by other methods is a factor indicating control by the employer over the particular method of performance.
- Integration of Services. integration of the person's services in the business operations generally shows that he or she is subject to direction and control.
- Personal Nature of Services. If the services must be rendered personally, it indicates an interest in the methods, as well as the results. Lack of control may be indicated when the person has the right to hire a substitute with the permission or knowledge of the employer.
- Similar workers. Hiring, supervising, and payments to assistants on the same job as the worker generally show employer control over the job.
- Continuing Relationship. The existence of a continuing relationship between an individual and the person for whom he or she performs services tends to indicate an employer-employee relationship.
- Hours of work. The establishment of set hours of work by the employer prevents the worker from being master of their own time, which is the right of the independent contractor.
- Full-time Work. Full-time work required for the business indicates control by the employer since it restricts the worker from doing other gainful work.
- Work on the Premises. If the worker is required to do the work on the employer's premises, employer control is implied, especially where the work is of such a nature that it could be done elsewhere.
- Order of Performance. If the order of the performance of services is or may be, set by the employer, control by the employer may be indicated.
- Submitting Reports. The submission of regular oral or written reports indicates control since the worker must account for his or her actions.
- Method of Payment. If the manner of payment is by the hour, week or month, an employer-employee relationship probably exists; whereas, payment on a commission or job basis is customary where the worker is an independent contractor.
- Payment of Expenses. Payment of the worker's business expenses by the employer indicates control of the worker.
- Tools and Materials. The furnishing of tools, materials, etc., by the employer, indicates control over the worker.
- Investment. A significant investment by the worker in facilities used in performing services for another tends to show an independent status.
- Profit or Loss. The possibility of a profit or loss for the worker as a result of services rendered generally shows independent contractor status.
- Exclusivity of Work. Work for a number of persons at the same time often indicates independent contractor status because the worker is usually free, in such cases, from control by any of the firms.
- Available to General Public. The availability of the services of the worker to the general public usually indicates independent contractor status.
- Right of Discharge. The right of discharge is that of an employer. An independent contractor, on the other hand, cannot be "fired" without incurring liability if he or she is producing a result that measures up to his contract specifications.
- Right to Quit. The right to quit at any time without incurring liability indicates an employer-employee relationship.
U. S. Department of Labor Status Tests
The Department of Labor (DOL) has a new test for clarifying worker status to determine whether the person is an employee included under the Fair Labor Standards Act. The effective date of this rule is indefinite because the Biden administration put a freeze on new regulations until they can be reviewed.
An economic reality test to determine whether the person is an independent business owner or an employee dependent on an employer for work
A set of two additional factors for clarification
- Nature and degree of control over work done
- Worker opportunity for profit or loss based on initiate and/or investment
Three additional factors to be used if there isn't agreement
- Amount of skill required for the work
- Degree of permanence of the work relationship
- Whether the work is an integral part of the business products or services
The DOL also notes that the existence of a contract or receipt of a 1099 form isn't as relevant as the actual practices.
This DOL Fact Sheet on Misclassification explains situations in which workers may be misclassified as independent contractors.
State Tests for Independent Contractor Status
Each state has its own way to evaluate the status of workers for state wages, hours, and working condition requirements. Several states - more all the time - are now using what's called a three-factor ABC test. This test, in brief, requires that all three of these factors must be met for the worker to be considered as an independent contractor:
- The worker is not under the control of the employer for the performance of work.
- The work must NOT be within the usual course of the employer's business, and
- The worker must be "customarily engaged" in an independent trade or business that is the same as the work performed for this employer.
Getting a Review by the IRS
Are you wondering if your workers are classified correctly? You can apply to the IRS using Form SS-8 to get a determination letter telling you how it sees your workers - as employees or independent contractors.
You may also apply to the IRS if you have been classifying workers as independent contractors. This application for "530 relief" allows you to get relief from liability or payment if you have been classifying workers as independent contractors in error. It looks at factors that might be in your favor as good faith efforts to comply with the law.