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Worker Classification: Employee or Contractor?
Worker classification is one of the most common, recurring tax
disputes. At its most basic level, the question boils down to this:
Is the worker an employee or an independent contractor? The risks
of getting it wrong can be significant: Back taxes, penalties, Affordable Care Act penalties, back wages-even
criminal exposure in some cases.
Worker classification determines whether an
employer is required to withhold income taxes and pay social
security, medicare taxes, and unemployment tax on the wages paid to
a worker. The general, black-letter law provides that a worker is
an independent contractor if the person or entity paying them has
the right to control or direct only the result of the work, not
what will be done to achieve that result or how
it will be done. Employers can have major-sometimes
existential-risk from misclassifying workers. If that risk exists,
they should contact a tax attorney proactively, as there may be
avenues for relief to remove that exposure.
How does a Worker Classification Audit Arise?
There are many potential avenues. For example, an employee may
inform the IRS of the misclassification. Or it may arise from a
state labor audit or Department of Labor audit through information
sharing agreements with the IRS. A worker-classification audit may
also arise from a whistleblower, a civil lawsuit, or a random
audit. And with states and the federal government short on cash,
worker classification audits will be on the rise.
Worker Classification, The Law
The Internal Revenue Code defines an employee for employment tax
purposes as “any individual who, under the usual common law
rules, applicable in determining the employer-employee
relationship, has the status of an employee.”
Under this test, whether a worker is classified as an
independent contractor or an employee is based upon an examination
of the relevant facts and circumstances and an application of
common law principles. Courts have generally looked to whether a
worker qualifies as an employee under common law principles.
Among the relevant factors in determining the proper
classification are the following: (1) The degree of control
exercised by the principal over the details of the work; (2) the
taxpayer’s investment in facilities; (3) the taxpayer’s
opportunity for profit or loss; (4) permanency of the relationship
between the parties; (5) the principal’s right of discharge;
(6) whether the work performed is an integral part of the
principal’s business; (7) what relationship the parties believe
they are creating; and (8) the provision of employee benefits.
Ultimately, all of the aspects of the relationship are relevant,
and the factors are not necessarily weighted equally, as their
significance varies from context to context.
Under Treasury regulations, the question of whether a worker
constitutes an “employee” largely boils down the degree
of control exercised by the employer over the individual. In this
regard, it is not necessary that the employer actually direct or
control the manner in which the services are performed; rather,
there is sufficient control if the employer has the right to do so.
The right to discharge is also an important factor when considering
the presence of an employment relationship.
The Common-Law Worker-Classification Rules
The IRS analyzes the evidence of the degree of control and
independence through three overarching categories:
- Behavioral: Does the company control or have
the right to control what the worker does and how the worker does
his or her job? - Financial: Are the business aspects of the
worker’s job controlled by the payer? (How is the worker paid?
Are expenses reimbursed? Who provides tools/supplies, etc.?) - Type of Relationship: Are there written
contracts or employee-type benefits (i.e. pension plan, insurance,
vacation pay, etc.)? Will the relationship continue and is the work
a key aspect of the business?
Businesses must weigh these factors when determining whether a
worker is an employee or an independent contractor. No one factor
stands alone in making this determination and the relevant factors
will vary depending on the facts and circumstances.
The Internal Revenue Service also utilizes the following 20
factors as an aid in determining the status of a worker’s
relationship:
- LEVEL OF INSTRUCTION. A worker who is required
to comply with other persons’ instructions about when, where,
and how he or she is to work is ordinarily an employee. This
control factor is present if the person or persons for whom the
services are performed have the right to require compliance with
instructions. - AMOUNT OF TRAINING. Training a worker by
requiring an experienced employee to work with the worker, by
corresponding with the worker, by requiring the worker to attend
meetings, or by using other methods, indicates that the person or
persons for whom the services are performed want the services
performed in a particular method or manner. - DEGREE OF BUSINESS INTEGRATION. Integration of
the worker’s services into the business operations generally
shows that the worker is subject to direction and control. When the
success or continuation of a business depends to an appreciable
degree upon the performance of certain services, the workers who
perform those services must necessarily be subject to a certain
amount of control by the owner of the business. - SERVICES RENDERED PERSONALLY. If the Services
must be rendered personally, presumably the person or persons for
whom the services are performed are interested in the methods used
to accomplish the work as well as in the results. - HIRING, SUPERVISING, AND PAYING ASSISTANTS. If
the person or persons for whom the services are performed hire,
supervise, and pay assistants, that factor generally shows control
over the workers on the job. However, if one worker hires,
supervises, and pays the other assistants pursuant to a contract
under which the worker agrees to provide materials and labor and
under which the worker is responsible only for the attainment of a
result, this factor indicates an independent contractor - CONTINUING RELATIONSHIP. A continuing
relationship between the worker and the person or persons for whom
the services are performed indicates that an employer-employee
relationship exists. A continuing relationship may exist where work
is performed at frequently recurring although irregular
intervals. - SET HOURS OF WORK. The establishment of set
hours of work by the person or persons for whom the services are
performed is a factor indicating control. - FULL TIME REQUIRED. If the worker must devote
substantially full time to the business of the person or persons
for whom the services are performed, such person or persons have
control over the amount of time the worker spends working and
impliedly restrict the worker from doing other gainful work. An
independent contractor on the other hand, is free to work when and
for whom he or she chooses. - DOING WORK ON EMPLOYER’S PREMISES. If the
work is performed on the premises of the person or persons for whom
the services are performed, that factor suggests control over the
worker, especially if the work could be done elsewhere. Work done
off the premises of the person or persons receiving the services,
such as at the office of the worker, indicates some freedom from
control. However, this fact by itself does not mean that the worker
is not an employee. The importance of this factor depends on the
nature of the service involved and the extent to which an employer
generally would require that employees perform such services on the
employer’s premises. Control over the place of work is
indicated when the person or persons for whom the services are
performed have the right to compel the worker to travel a
designated route, to canvass a territory within a certain time, or
to work at specific places as required. - ORDER OR SEQUENCE SET. If a worker must
perform services in the order or sequence set by the person or
persons for whom the services are performed, that factor shows that
the worker is not free to follow the worker’s own pattern of
work but must follow the established routines and schedules of the
person or persons for whom the services are performed. Often,
because of the nature of an occupation, the person or persons for
whom the services are performed do not set the order of the
services or set the order infrequently. It is sufficient to show
control, however, if such person or persons retain the right to do
so. - ORAL OR WRITTEN REPORTS. A requirement that
the worker submit regular or written reports to the person or
persons for whom the services are performed indicates a degree of
control. - PAYMENT BY HOUR, WEEK, MONTH. Payment by the
hour, week, or month generally points to an employer-employee
relationship, provided that this method of payment is not just a
convenient way of paying a lump sum agreed upon as the cost of a
job. Payment made by the job or on straight commission generally
indicates that the worker is an independent contractor. - PAYMENT OF BUSINESS AND/OR TRAVELING EXPENSES.
If the person or persons for whom the services are performed
ordinarily pay the worker’s business and/or traveling expenses,
the worker is ordinarily an employee. An employer, to be able to
control expenses, generally retains the right to regulate and
direct the worker’s business activities. - FURNISHING OF TOOLS AND MATERIALS. The fact
that the person or persons for whom the services are performed
furnish significant tools, materials, and other equipment tends to
show the existence of an employer-employee relationship. - SIGNIFICANT INVESTMENT. If the worker invests
in facilities that are used by the worker in performing services
and are not typically maintained by employees (such as the
maintenance of an office rented at fair value from an unrelated
party), that factor tends to indicate that the worker is an
independent contractor. On the other hand, lack of investment in
facilities indicates dependence on the person or persons for whom
the services are performed for such facilities and, accordingly,
the existence of an employer-employee relationship. See Rev. Rul.
71-524. Special scrutiny is required with respect to certain types
of facilities, such as home offices. - REALIZATION OF PROFIT OR LOSS. A worker who
can realize a profit or suffer a loss as a result of the
worker’s services (in addition to the profit or loss ordinarily
realized by employees) is generally an independent contractor, but
the worker who cannot is an employee. For example, if the worker is
subject to a real risk of economic loss due to significant
investments or a bona fide liability for expenses, such as salary
payments to unrelated employees, that factor indicates that the
worker is an independent contractor. The risk that a worker will
not receive payment for his or her services, however, is common to
both independent contractors and employees and thus does not
constitute a sufficient economic risk to support treatment as an
independent contractor. - WORKING FOR MORE THAN ONE FIRM AT A TIME. If a
worker performs more than de minimis services for multiple
unrelated persons or firms at the same time, that factor generally
indicates that the worker is an independent contractor. However, a
worker who performs services for more than one person may be an
employee of each of the persons, especially where such persons are
part of the same service arrangement. - MAKING SERVICE AVAILABLE TO THE GENERAL
PUBLIC. The fact that a worker makes his or her services
available to the general public on a regular and consistent basis
indicates an independent contractor - RIGHT TO DISCHARGE. The right to discharge a
worker is a factor indicating that the worker is an employee and
the person possessing the right is an employer. An employer
exercises control through the threat of dismissal, which causes the
worker to obey the employer’s instructions. An independent
contractor, on the other hand, cannot be fired so long as the
independent contractor produces a result that meets the contract
specifications. - RIGHT TO TERMINATE. If the worker has the
right to end his or her relationship with the person for whom the
services are performed at any time he or she wishes without
incurring liability, that factor indicates an employer-employee
relationship.
Ordinarily, the principal’s right to control the manner in
which the work is performed is the most important factor in
determining whether there is an employer-employee relationship.
A Path Forward
Worker classification presents a major business risk-implicating
tax, labor, and civil litigation risks, among others. If worker
classification exposure exists, a business should contact a tax
attorney proactively, as there may be avenues for relief to remove
that exposure. We frequently assist clients with worker agreements
and contracts, risk exposure mitigation, audit representation, and,
where necessary, serve as litigation counsel.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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