What are the parameters around classifying a worker as an independent contractor? If you own a business or operate in an industry that requires some form of frequent, ongoing, or even semi-regular input into your product/service from other individuals, you may be asking yourself, is this person(s) an employee of mine or an independent contractor? The answer to this question may be more perplexing than it would seem at first. And, make no mistake about it; misclassifying this distinction in how we treat workers can have very real, even negative, financial ramifications on us and our businesses! Getting it right is key.
IRS Categories for workers
The IRS has four distinct categories for workers. They are independent contractor, employee, statutory employee, and statutory nonemployee. Knowing which one your worker falls under is the key to determine if you owe any SS, Medicare, and unemployment tax on their labor.
Generally, there are 3 common law rules that determine control and the level of independence over services being provided to you. These 3 rules are:
- Behavioral – Does the company control or have right to control who and how work is done?
- Financial – Are the business aspects of the workers job controlled by the payer?
- Type of relationship – Are there contracts, employee-type benefits, a continuous relationship, and is the work being performed a key aspect of the business?
Furthermore, the IRS has what they call a “right to control” or “20-factor common-law” test that examines these 3 general rules. The 20 points are utilized due to the fact that under IRS rules and Common-law doctrine, independent contractors control the manner and means by which contracted services, products or results are achieved. The more control exercised by a company or employer, the more likely workers are to be considered employees. The 20 factors to consider are as follows:
- Level of Instruction – Does the company direct who, when, where, and how work is done?
- Amount of training – Are workers mandated to undergo company-provided training?
- Degree of business integration – Are workers duties/services integrated into business operations or significantly affecting the success of the business?
- Extent of personal services – Does the company assign specific work to specific persons?
- Control of assistants – Does the company hire, supervise and pay the assistants to the worker?
- Continuity of relationship – Is the relationship continuous?
- Flexibility of schedule – Are the individuals hours and days of work dictated by the payer providing the work?
- Demands for full-time work – Has the worker been given full time work by the payer?
- Need for on-site services – Does the individual work on the payer’s premises? Can the work be performed from a location other than the payer’s premises?
- Sequence of work – Does the payer require work to be performed in a specific order or sequence?
- Requirements for reports – Is the worker required to regularly provide written or oral reports on the status of a project?
- Method of payment – Does the worker receive regular pay? (Aside from the convenience of smaller payments against a lump sum.)
- Payment of business or travel expenses – Does the payer or the worker pay for any cost of travel or business expenses?
- Provision of tools and materials – Does the worker or the payer provide the worker with the necessary tools and supplies for the job?
- Investment in facilities – Does the worker rely on the company to provide work facilities, or do they invest in and maintain their own work facilities?
- Realization of profit or loss – Does the worker receive predetermined earnings and have little chance to realize significant profit or loss through their work?
- Work for multiple companies – Does the worker provide services for several unrelated companies?
- Availability to public – Are the worker’s services regularly available to the general public?
- Control over discharge – Does the company have the unilateral right to discharge the worker? Is there a contract agreement between the company and worker preventing the company from discharging the worker at-will?
- Right of termination – Does the worker have the unilateral right to terminate their employment without liability?
There is no pre-determined number of the 20 factors that either make or break the distinction between employee and contractor. This is simply a diagnostic to gage the 3 key factors that the IRS uses in their determination and is also what IRS form SS-8 is largely derived from.
Extremely important to issue a 1099 to your independent contractor
And here’s another very important factor…be sure to issue 1099s to those workers you are treating as independent contractors. Because, if the IRS were to ever challenge your treatment of those workers, and reclassify them as employees, you want to be able to rely on section 530 relief under the Revenue Act of 1978 for your past treatment of those workers.
Section 530, is a safe harbor provision that prevents the IRS from retroactively reclassifying independent contractors as employees and subjecting the ‘employer’ to federal employment taxes, penalties and interest for misclassification. In order to qualify for section 530 relief, an employer must have:
- Consistently treated the workers, and any similarly situated workers, as independent contractors
- Complied with the Form 1099 reporting requirements with respect to the compensation paid to the workers for the tax year(s) in question
- Had a reasonable basis for treating the workers as independent contractors. A reasonable basis can be formed by any of the following:
- A taxpayer may rely on any federal judicial precedent or published revenue ruling if they can demonstrate a reasonable similarity to the case and their personal situation. Although, it need not be identical, or even in the same industry.
- Any prior audits of the taxpayer. Especially ones that have specifically dealt with the classification of the workers in question, or similarly situated workers.
- Employers may rely on industry custom or practice if it is a long-standing custom and utilized in a significant portion of the industry. According to section 530, a long-standing practice would be 10 years of existence and a significant portion of the industry would be as little as 25 percent (aside from the taxpayer), although, a lower percentage may qualify depending on facts and circumstances.
- Any other ‘reasonable basis’. This is a final safe harbor in favor of the taxpayer, and is intentionally left open-ended for that very reason. This could include advice from an accountant or attorney so long as the individual is licensed in their field and the advice was given and relied upon when the worker began treatment as an independent contractor. The common law rules would be considered acceptable for this safe harbor and prior state administrative or other federal determinations may constitute a reasonable basis for section 530 relief.
Section 530 does not make or validate workers as independent contractors but rather classifies them as “non-employees” for federal employment tax purposes. Nevertheless, this is an important part of understanding how workers should be classified for federal tax purposes, and being cognizant of the protections afforded to you in the event of an IRS audit.
Essentially, if you treat all contracted workers similarly, file 1099’s for all such workers, have some reasonable basis for treating them as independent contractors, and maintain adequate records to validate all of this, you should have confidence in your decision to classify them as independent contractors.