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.