Introduction and Legal Disclaimer

Whether a worker is an independent contractor or employee is a question that often has no definitive answer. By its nature the determination requires a weighing of multiple imprecise factors, many of which may point to different conclusions. Getting the answer wrong can leave businesses subject to significant tax and penalty assessments.

Getting the answer right has now taken on a new urgency as the result of an increased focus by the IRS on worker classification, since the employment tax system now accounts for more than 60% of federal revenues. An IRS program of employment tax National Research Project (NRP) examinations began in February 2010. Under this NRP program, the IRS will randomly select 6000 taxpayers from various business divisions and audit 2,000 taxpayers per year for employment tax compliance in each of the three years from 2010 to 2012. Agents will be specially trained to gather information to improve its regular employment tax audit program and thereby increase compliance. One must assume that the IRS will use the data derived from this program to substantially increase its regular employment tax audit programs going forward.

This article is general and informational in nature and you should read the terms of our legal disclaimer regarding its use.

Tax Issues

Common Law

If a worker is classified as an employee, the employer must abide by tax and labor law requirements, such as withholding taxes, paying for workmen’s compensation, and paying for unemployment tax. These requirements are avoided if a worker is an independent contractor. In most cases the determination of whether a worker is an independent contractor or employee is based at least in part on an analysis of “twenty factors” which have developed under common law.

The twenty factors of common law used in making determinations of independent contractor status by the IRS listed in Revenue Ruling 87-41

  1. Instructions
  2. Oral or Written Reports
  3. Training
  4. Payment by Hour, Week, Month
  5. Integration
  6. Payment of Business
  7. Services Rendered Personally
  8. Furnishing of Tools and Materials
  9. Hiring/Supervising/Paying Assistants
  10. Significant Investment
  1. Continuing Relationship
  2. Realization of Profit or Loss
  3. Set Hours of Work
  4. Making Services Available to General Public
  5. Full Time Required
  6. Working for More Than one Firm at a Time
  7. Doing Work on Employer’s Premises
  8. Right to Discharge
  9. Order or Sequence Set
  10. Right to Terminate

The IRS primarily looks at the level and nature of the employer’s control over the worker to determine if the worker is an employee or independent contractor. When an employer instructs, trains, supervises, sets hours of work, provides materials, and requires the work to be performed on the employer’s premises, the employer is exercising control. The IRS weighs these considerations, among others, when classifying a worker as an employee or independent contractor. Simply calling a worker an independent contractor, whether informally or in a formal employment agreement is insufficient in and of itself to assure independent contractor classification.

Worker Classification Audit

An audit may include interviewing the employer and worker, and reviewing any contract between the parties. Additionally, an employer must maintain all employment tax records for at least 4 years. For an independent contractor, an employer would not have employment tax records but the employer should keep records documenting the relationship.

Section 530 Relief

Employers who misclassify their workers as independent contractors may find employment tax relief under § 530 of the Internal Revenue Code. This relief does not change the worker’s status or relieve the worker of his or her share of employment taxes. Relief is only available if the employer’s classification of the worker as an independent contractor was reasonable and the employer timely filed all the required informational returns.

Non-Tax Issues

Unemployment Insurance

Unemployment insurance tax audits are done by the Labor Department and are separate from audits done by the tax authorities. Employers must maintain accurate records of each employee for the current and three preceding years. The records must show each employee’s name, social security number, the days the employee worked, and any pay, including vacation and bonuses, earned by the employee.

Fair Labor Standards Act (FLSA)

The FLSA provides minimum wage and overtime protections for employees. The “economic reality test” is used to determine if a worker is an employee. The “economic reality test” uses several factors, such as the amount of control the employer has over the worker, the worker’s investment in the business, the worker’s skill and independence, how long the relationship has lasted, and how integral the work is to the employer’s business. All these factors are considered collectively in the determination.

Immigration Reform and Control Act of 1986 (IRCA)

IRCA requires employers to maintain records showing employees’ identity and right to work in the U.S. IRCA makes it unlawful to hire an employee without obtaining proof that the employee is authorized to work in the U.S. and an employer must prepare within 3 days of hire an I-9 Employment Eligibility Verification form, which must be kept for at least 3 years. The U.S. Department of Homeland Security’s Immigration and Customs Enforcement and the U.S. Department of Labor’s Employment Standards Administration can conduct audits to ensure compliance with IRCA. The factors considered to determine a worker’s status are similar to the common law factors, mainly focusing on the employer’s control over the worker.