White Paper published by The HR Specialist, copyright 2007
For years, the IRS has relied on a 20-factor test to determine whether a worker is considered an "employee" or an "independent contractor." Conferring contractor status on a worker often benefits the employer, who is then not obligated to withhold income tax or to pay Social Security and unemployment taxes.
The 20-factor test has been losing ground in the courts and in Congress. Recognizing this, the IRS published new instructions to help auditors (and employers) determine worker status.
The guidelines set forth three main categories of evidence that the agency thinks are most important in making the determination. Following is an abbreviated synopsis of each factor, as summarized with permission by Vern Hoven, CPA, of The California Enrolled Agent magazine:
I. Does behavioral control over the worker exist?
Behavioral control focuses on whether the business has the right to direct or control how the work is done, e.g., how the worker performs the specific task for which he was hired. Factors include:
1. To what extent are instructions given and taken? An employee is generally subject to the business's instructions about when, where, and how to work; an independent contractor is not. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how work results are achieved. Pertinent evidence includes: (1) needing prior approval before proceeding, (2) rendering services personally and (3) hiring, supervising and paying assistants.
2. What training does the business give the worker? Employees may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods. The company's orientation course, safety seminars and voluntary unpaid educational programs are to be disregarded.
II. Do financial controls over the worker exist?
These factors illustrate whether there is a right to control how the business aspects of the worker's activities are conducted:
3. Can the worker realize a profit or incur a loss? A contractor can make a profit or loss, whereas an employee can only make a profit.
4. Is the worker's investment significant? An independent contractor often has a significant investment in the equipment or facilities he uses in performing services for someone else. However, a significant investment is not required. Pertinent evidence includes: (1) amount of unreimbursed expenses, (2) payment of business and/or travel expenses, (3) furnishing of tools and materials and (4) analysis of lease arrangements between worker and business. The IRS has listed business expenses expected to be found on the taxpayer's business return.
5. To what extent does the worker make services available to the general public? Pertinent evidence includes: (1) Yellow Page advertising, (2) working for more than one firm and (3) identifying cases in which advertising is not required, .e.g., use of word-ofmouth advertising.
6. How does the business pay the worker? An employee is generally paid by the hour, week or month. An independent contractor is generally paid a flat fee or by the job, even though it is common in some professions, such as law and accounting, to pay hourly.
III. What type of relationship between the parties exist?
These factors illustrate how the worker and the business perceive their relationship:
7. Does a written contract exist that describes the relationship the parties intend to create? This is a new factor generally considered of lesser importance by the IRS (but more important by the courts!), as the substance, not the label, governs the worker's status. A written contract contains other evidence- for example, the method of compensation, which expenses are reimbursed and how work is to be performed.
8. Does the business provide the worker with employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay? Employee benefits are only paid to employees. The IRS surprisingly discloses that W-2's do not necessarily indicate employee status, incorporated workers generally will not be recharacterized as the business's employees, and state law determination (or other government or industry imposed regulations) is not a relevant indicator of employer-employee status.
9. How permanent and ongoing is this relationship? Permanent and indefinite relationships indicate an employer-employee relationship, whereas, the IRS divulges, long-term and temporary relationships are not important evidence (e.g., contractors can have long-lasting relationships).
10. To what extent are the services performed by the worker a key aspect of the regular business of the company? Is the success of the business dependent, to an appreciable degree, upon the worker's performance? If so, an employer-employee relationship exists. For example, as restaurants need cooks and cashiers and law firms need lawyers, these workers are generally employees. But, even though it is essential for an appliance store to retain good accountants, bookkeeping is not the store's regular business and therefore this work can be done equally well by independent contractors or employees.
Factors the IRS Now Considers of Lesser Importance
The IRS de-emphasized its focus on several other factors that were previously used in the old 20-factor test, including:
1. Does the client/customer have the right to discharge the worker?
2. Does the worker have the right to terminate the relationship?
3. Can the worker work part time or is full time required?
4. Must the work be performed on the employer's premises?
5. Who sets the hours to be worked?
6. Must the work be performed in an order or sequence?