Federal Independent Contractor versus Employee

Introduction and Legal Disclaimer

The distinction between Independent Contractor and Employee is of major concern to both businesses and the various taxing authorities. Yet 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 both businesses and the workers servicing those businesses subject to significant tax and penalty assessments.

Historically, businesses often preferred treating individuals as independent contractors, while the various taxing authorities had a marked preference for employee status. Those preferences have, in many instances, now been upended by the passage of §199A of the Internal Revenue Code (“IRC”) as part of the Tax Cuts and Jobs Act (“TCJA”) in 2017. Section 199A provides for a Qualified Business Income Deduction of 20% for, among others, independent contractors in a variety of businesses. As a result, the classification of individuals performing services as independent contractors or employees is constantly under scrutiny, and often the subject of controversy between the taxing authorities, employers, and their workers.

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

11. Continuing Relationship
12. Realization of Profit or Loss
13. Set Hours of Work
14. Making Services Available to General Public
15. Full Time Required
16. Working for More Than one Firm at a Time
17. Doing Work on Employer’s Premises
18. Right to Discharge
19. Order or Sequence Set
20. 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. In January 2021, in the waning days of the Trump administration, the Department of Labor promulgated a “Final Rule” applying an “economic reality test” to determine if a worker is an employee or independent contractor. That proposed final rule elevated some of the traditional factors over others in making a determination. However, shortly thereafter, in May 2021, the DOL withdrew the final rule, returning us to reliance on the factors from caselaw originally established in 1947. It remains to be seen whether the current DOL will attempt to modify those rules going forward.

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.