The classification of workers as employees or independent contractors determines whether an employer is responsible for withholding and paying payroll taxes. The worker's classification is based chiefly on whether you have the right to direct or control the worker's work. The IRS has a 20-factor analysis you can use to assist you in making a determination. There is also a safe haven rule, as well as the opportunity to request a ruling from the IRS as to employee or independent contractor status.
The obligation to withhold and to pay payroll taxes applies to employers with workers who are properly classified as employees as opposed to independent contractors. The key word is "properly" classified.
The benefit of having workers classified as independent contractors is that generally, businesses are not responsible for payroll tax obligations. On the other hand, only in rare circumstances will a business be relieved from payroll tax obligations with respect to employees. Proper classification requires that a business follow detailed criteria to distinguish between employees and independent contractors.
The IRS and the various state tax agencies rely on common law rules to distinguish employees from independent contractors. Under these rules, your workers are employees if you have the right to direct and control them in the way they work, both as to the final results and as to the details of when, where, and how their work is done.
Even if you grant your workers considerable discretion in determining how they do their work, as long as you retain the legal right to control their activities, the workers are common-law employees.
There are innumerable ways in which you can exercise control over a worker. There is no clear definition of just how much control on your part is enough to cause a worker to be classified as an employee rather than an independent contractor. Each case depends on an analysis of its own particular set of facts.
To assist you with this analysis:
- The IRS has published the 20 factors that its auditors use as guidelines in resolving the employee-or-contractor issue.
- There is a "safe haven" rule that generally allows you to treat a worker as not being an employee for employment tax purposes, regardless of the worker's actual status under the common-law test, under certain specified circumstances.
- You can obtain an IRS determination of the worker's status, if you're still uncertain about a worker's proper classification.
Misclassification of workers is a red flag for the IRS and the courts. Employers often hold the common misconception that they can avoid incurring payroll tax obligations simply by having their workers sign agreements that declare the workers to be independent contractors. Such self-serving agreements carry little, if any, significance under the common-law rules.
If your actions show an employer-employee relationship, then your workers are employees regardless of how you choose to describe them.
The IRS's 20-factor analysis
When IRS auditors analyze whether a worker is an employee or independent contractor, they generally work through a list of 20 different factors before concluding whether a sufficient level of control is present to create an employer-employee relationship. They also look at any other information that helps determine the degree of control and the degree of independence. The IRS generally groups evidence regarding a right to control into three primary categories:
- behavioral control—regarding how a worker performs the work (e.g., instructions, training);
- financial control—regarding the business aspects of the worker’s activities (e.g., unreimbursed expenses, profit or loss opportunity, payment method, significant investment, services available to the relevant market);
- relationship of the parties—regarding how the business and worker perceive their relationship (e.g., employee benefits, written contracts/intent of parties, discharge/termination, regular business activity).
You should go through this same exercise, particularly if you're trying to claim that someone who does work for you is an independent contractor and not your employee.
Keep in mind that the importance of each fact will vary depending on the type of work being done and the circumstances of your own particular case.
Because this is a rather subjective analysis, your goal should be to honestly assess how great a risk you'll be taking if you plan to treat a worker as an independent contractor. In close cases, talk to your tax professional or request an IRS determination of the worker's status.
- Instructions. Workers who must comply with your instructions as to when, where, and how they work are more likely to be employees than independent contractors.
- Training. The more training your workers receive from you, the more likely it is that they're employees. The underlying concept here is that independent contractors are supposed to know how to do their work and, thus, shouldn't require training from the purchasers of their services.
- Integration. The more important that your workers' services are to your business's success or continuation, the more likely it is that they're employees.
- Services rendered personally. Workers who must personally perform the services for which you're paying are more likely employees. In contrast, independent contractors usually have the right to substitute other people's services for their own in fulfilling their contracts.
- Hiring assistants. Workers who are not in charge of hiring, supervising, and paying their own assistants are more likely employees.
- Continuing relationship. Workers who perform work for you for significant periods of time or at recurring intervals are more likely employees.
- Set hours of work. Workers for whom you establish set hours of work are more likely employees. In contrast, independent contractors generally can set their own work hours.
- Full time required. Workers whom you require to work or be available full time are likely to be employees. In contrast, independent contractors generally can work whenever and for whomever they choose.
- Work done on premises. Workers who work at your premises or at a place you designate are more likely employees. In contrast, independent contractors usually have their own place of business where they can do their work for you.
- Order or sequence set. Workers for whom you set the order or sequence in which they perform their services are more likely employees.
- Reports. Workers whom you require to submit regular reports are more likely employees.
- Payment method. Workers whom you pay by the hour, week, or month are more likely employees. In contrast, independent contractors are usually paid by the job.
- Expenses. Workers whose business and travel expenses you pay are more likely employees. In contrast, independent contractors are usually expected to cover their own overhead expenses.
- Tools and materials. Workers who use tools, materials, and other equipment that you furnish are more likely employees.
- Investment. The greater your workers' investment in the facilities and equipment they use in performing their services, the more likely it is that they're independent contractors.
- Profit or loss. The greater the risk that your workers can either make a profit or suffer a loss in rendering their services, the more likely it is that they're independent contractors.
- Works for more than one person at a time.The more businesses for which your workers perform services at the same time, the more likely it is that they're independent contractors.
- Services available to general public. Workers who hold their services out to the general public (for example, through business cards, advertisements, and other promotional items) are more likely independent contractors.
- Right to fire. Workers whom you can fire at any time are more likely employees. In contrast, your right to terminate an independent contractor is generally limited by specific contractual terms.
- Right to quit. Workers who can quit at any time without incurring any liability to you are more likely employees. In contrast, independent contractors generally can't walk away in the middle of a project without running the risk of being held financially accountable for their failure to complete the project.