Is Your Worker an Independent Contractor or an Employee? A Crucial Guide for Employers
Determining whether a worker is an employee or an independent contractor is one of the most critical and complex decisions an employer makes. Consequently, making the wrong choice carries significant risks. The IRS and various state agencies carefully scrutinize this classification. Therefore, it’s essential to understand the difference. Ultimately, misclassifying an employee as an independent contractor can result in huge penalties.
This guide will break down the essential tests and factors. Furthermore, we’ll provide actionable advice to ensure your compliance.
Why Does the Independent Contractor vs. Employee Distinction Matter?
The distinction is vital due to the varying legal obligations. Employers have far fewer duties regarding an independent contractor than they do regarding an employee.
- Taxes: Employers do not withhold federal, state, and local taxes from wages paid to independent contractors. However, they must withhold these taxes from employees.
- Benefits and Laws: Independent contractors are generally exempt from wage and hour laws, employment discrimination laws, and unemployment insurance. They are also typically not included in an employer’s benefits programs.
- Penalties: Penalties for misclassification can include back taxes, premiums, civil fines, interest, and other retroactive damages. Consequently, you must exercise extreme caution when classifying a worker.
Understanding the Key Test: The Right to Control
The foundation for proper classification is the common law test. According to this IRS guideline, an employer-employee relationship exists if the employer has the right to control and direct the worker. This control extends to the results, the specific details, and the means by which the work is accomplished.
An independent contractor has greater control over how they carry out their work. Furthermore, this individual is typically engaged in their own independent trade or business. The key thing to remember is who has the right to control when and how the work is completed.
How Does the IRS 20-Factor Test Help Determine Status?
The IRS developed the 20-Factor Test to help employers evaluate worker status. No single factor is definitive. Instead, you should look at the worker’s status holistically.
A high number of “yes” answers on the test suggests an employment relationship. Meanwhile, a high number of “no” marks may or may not indicate a contractor relationship. Therefore, always err on the side of caution.
We can group the 20 factors into three main categories of evidence: behavioral control, financial control, and the type of relationship.
1. Behavioral Control Factors
This section examines the employer’s right to direct and control how the worker performs the task.
| Factor | Key Question |
|---|---|
| Instructions | Is the worker required to comply with the employer’s instructions about when, where, and how to work? |
| Training | Is training required or provided by the employer? |
| Integration | Are the workers’ services integrated with the company’s activities? Does business success significantly depend on their services? |
| Services Rendered Personally | Is the worker required to perform the work personally? |
| Assistants | Does the worker lack the authority to hire, supervise, and pay assistants? |
| Continuing Relationship | Does the worker have a continuing relationship with the employer? |
| Set Hours of Work | Is the worker required to follow set hours of work? |
| Full-time Work Required | Does the worker work full-time for the employer? |
| Place of Work | Does the worker perform work on the employer’s premises and use company office equipment? |
| Sequence of Work | Does the worker perform work in a sequence set by the employer? |
| Reporting Obligations | Does the worker submit regular written or oral reports to the employer? |
2. Financial Control Factors
These factors illustrate the extent to which the worker has control over the business aspects of their job. An independent contractor typically bears more financial risk.
| Factor | Key Question |
|---|---|
| Method of Payment | Does the worker receive regular payments at set intervals, regardless of project completion? |
| Business/Travel Expenses | Does the worker receive payment for business and travel expenses? |
| Furnishing of Tools/Materials | Does the worker rely on the employer for tools and materials? |
| Investment | Has the worker not made an investment in the facilities or equipment used? |
| Risk of Loss | Is the payment made to the worker on a fixed basis regardless of profitability or loss? |
| Working for More Than One Company | Does the worker only work for one employer at a time? |
| Availability of Services to Public | Are the worker’s services unavailable to the general public? |
3. Type of Relationship Factors
This section focuses on how the employer and worker perceive their relationship.
| Factor | Key Question |
|---|---|
| Right to Discharge | Can the worker be fired by the employer? |
| Right to Quit | Can the worker quit work at any time without liability? |
Actionable Advice: How to Protect Your Business
Classification is difficult for many small and medium businesses (SMBs). Here are practical steps to mitigate risk.
1. Always Document Your Classification
Have a clear, written agreement with your independent contractor. This agreement should specify the services and the independent nature of the relationship. It should also state that the contractor controls the manner and means of the work.
2. Consider the “Reasonable Basis” Test
The “Reasonable Basis” test offers a “safe harbor” against IRS challenges. This prevents the IRS from penalizing you for misclassification if certain conditions are met.
You must meet three conditions to qualify for this protection:
- Consistent Treatment: You have always treated the worker as an independent contractor.
- Consistent Filing: You have filed all required returns, consistent with the contractor status, for all periods after 1978.
- Reasonable Rationale: You had a reasonable basis for the treatment. This basis can be reliance on a prior IRS audit or a longstanding practice in your industry.
3. Seek an Official Determination When in Doubt
If you are unsure, pursue an official IRS ruling. Both employers and workers can file Form SS-8 (Determination of Employee Work Status). This form asks the IRS to determine the worker’s status for federal employment tax and income tax withholding purposes.
Moving Forward with Confidence
Correctly classifying your workforce is not just a compliance issue; it’s a business fundamental. Missteps can lead to unexpected tax liabilities and legal matters. Therefore, understanding the nuances of the independent contractor classification is crucial.
If the 20-Factor Test leaves you with more questions, you’re not alone. Our solutions at AccuPay are designed to simplify payroll and HR complexities for SMBs. We help ensure that your worker classifications are managed accurately, reducing your risk and freeing you to focus on your business’s success.