How the IRS Determines Independent Contractor Status

Independent Contractor Tests Explained

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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 ICs 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 ICs instead of employees can result in high costs, including paying workers amounts owed for FICA taxes (Social Security and Medicare), and heavy fines and penalties.

IRS vs. Department of Labor Classification

The IRS separates and classifies workers as ICs or employees for employment tax purposes. As noted above, ICs are not subject to these taxes and businesses don't have to contribute to these taxes.

The Department of Labor (DOL) uses a different classification system to determine worker status for purposes of wage and hour laws, including minimum wages, overtime, and child labor laws. ICs 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 IC under one rule and be classified as an employee under another.

How the IRS Determines Worker Status

The IRS uses common law principles to determine if a worker is an IC 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 ICs or employees. These factors have been compressed into three general categories for IRS review of the specific situation:

  • Behavioral control
  • Financial control
  • 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 that determine status.

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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.

IRS 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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Similar workers. Hiring, supervising, and payments to assistants on the same job as the worker generally show employer control over the job.
  6. 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.
  7. 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 IC.
  8. 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.
  9. 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.
  10. 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.
  11. Submitting reports. The submission of regular oral or written reports indicates control since the worker must account for their actions.
  12. 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 IC.
  13. Payment of expenses. Payment of the worker's business expenses by the employer indicates control of the worker.
  14. Tools and materials. The furnishing of tools, materials, etc., by the employer, indicates control over the worker.
  15. Investment. A significant investment by the worker in facilities used in performing services for another tends to show an independent status.
  16. Profit or loss. The possibility of a profit or loss for the worker as a result of services rendered generally shows IC status.
  17. Exclusivity of work. Work for a number of persons at the same time often indicates IC status because the worker is usually free, in such cases, from control by any of the firms.
  18. Available to general public. The availability of the services of the worker to the general public usually indicates IC status.
  19. Right of discharge. The right of discharge is that of an employer. An IC, on the other hand, cannot be "fired" without incurring liability if they are producing a result that measures up to their contract specifications.
  20. Right to quit. The right to quit at any time without incurring liability indicates an employer-employee relationship.

U. S. Department of Labor Worker Status Test

The DOL determines worker status by looking at whether an "employment relationship" exists between a worker and an employer. If this relationship exists, then the worker is considered to be an employee under the provisions of the Fair Labor Standards Act (FLSA). These provisions include regulations for minimum wages, overtime, and youth workers.

An employee in this context is not someone who has a business of their own but is dependent on the business they serve. The text of the employee-employer relationship under the FLSA is what the DOL calls "economic reality."

Some of the factors that the Supreme Court has found to be significant, and which the DOL looks at, are:

  • Whether the services of the worker are part of the basic business of the employer
  • The permanency of the relationship
  • How much the worker invests in facilities and equipment
  • How much control the employer has over the worker
  • The worker's opportunity for profit and loss
  • The amount of initiative, judgment, or foresight the person needs to compete in the open market
  • The degree of independent business organization and operation.

Some factors aren't important in determining the existence of an employment agreement., including

  • Whether there is a formal employment contract
  • Where the work is performed
  • Whether the worker is licensed
  • The time or method of payment

This DOL Fact Sheet on Misclassification explains situations in which workers may be misclassified as ICs.

The Department of Labor announced a new final rule in January 2021 for determining worker status. This final rule, however, was withdrawn on May 5, 2021.

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 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 IC:

  1. The worker is not under the control of the employer for the performance of work.
  2. The work must not be within the usual course of the employer's business.
  3. 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 ICs.

You may also apply to the IRS if you have been classifying workers as ICs in error. This application for "530 relief" allows you to get relief from liability or payment if you have been classifying workers as ICs in error. It looks at factors that might be in your favor as good faith efforts to comply with the law.