During the spring of 2010, the Internal Revenue Service (IRS) began an employment tax research study that focused on areas of employment taxes with the most compliance issues. One of these issues was whether or not business owners were correctly classifying individuals who provide services as employees or as an independent contractor.
Generally when an employer hires an individual as an employee, they must pay Social Security, Medicare, and unemployment taxes. If they decide to hire that person as an independent contractor, they generally would not have to pay such taxes providing a tax break for the employer. This provides an incentive for employers to treat an employee as an independent contractor which may lead to the payment of liable employment taxes for that worker.
The IRS estimated that business owners have misclassified millions of workers as independent contractors causing the federal government to lose at least $3-4 billion dollars annually. Since the study commenced, the amount of court cases and legal victories for misclassified workers have significantly risen causing many small and large companies substantial litigation costs. As an employer or as a new hire, it is critical to define the exact business relationship between the worker and the employer prior to beginning any work.
Defining Independent Contractors
Independent contractors provide goods or services to another entity that are specified in a contract or verbal agreement. The contractor however is not subjected to the employer’s control or guidance except as to what is in the agreement. Also unlike an employee, a contractor usually does not work regularly for the employer, but only when it is required. For some jobs, the line between the two is often blurred making determination difficult. For guidance, the IRS lists three provisional tests in order to distinguish between the two classifications.
According to the IRS, the facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral Control – This refers to facts that show whether there is a right to direct or controls how the worker completes their given job tasks. Generally, independent contractors are not restricted by:
- Type of instructions given by an employer
- Degree of instruction by an employer
- Evaluation systems by the employer
- Training provided by the employer
Financial Control – This refers to facts that show whether or not the entity has the right to control the economic aspects of the worker’s job. Independent contractors are more likely to incur:
- Significant investment in equipment
- Unreimbursed expenses
- Opportunity for profit or loss
- Ability to seek out business opportunities in the relevant market
- Payment by a flat fee for the job
Type of Relationship – This refers to facts that show how the worker and employer view their relationship to each other and how they work together. Generally independent contractors do not have:
- Benefits provided by the employer
- Permanency of the relationship
- Provided services of key business activity
Employers must weigh in all of these factors when classifying workers. As the IRS states, there is not really any “magic” set number of factors that ultimately determine the classification. The key to using this test lies in viewing the entire relationship and the amount of direct control the employer has.
If it is still unclear whether or not a worker is an employee or an independent contractor, filling out Form SS-8 – Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding is recommended. The form (PDF) is currently available online at:
Although this form allows the IRS to personally review the facts and circumstances to determine the status, it usually takes at least six months to get the determination. If more of an immediate response is needed, it is recommended to seek guidance from a professional business consultant or a licensed Certified Public Accountant (CPA).
Written by Amit K. Saha, Senior Accountant