Making the proper determination on whether to treat a worker as an employee or independent contractor can have significant tax implications. A lot of taxpayers feel they can just classify the worker how they want, however there are numerous situations that you need to look at. The following is a law section on a memo I drafted detailing the rules of how to classify a worker. Most of the information can be found in the IRM too:
IRC section
3121(d)(2) of the Internal Revenue Code provides that the term
"employee" means any individual who, under the usual common law rules
applicable in determining the employer-employee relationship, has the status of
employee. See also IRC sections 3401(c) and 3306(i).
The question of
whether an individual is an independent contractor or employee is one of fact
to be determined upon consideration of the facts and application of the law and
regulations in a particular case. With certain limited statutory exceptions,
the classification of particular workers or classes of workers as employees or
independent contractors, for purposes of Federal employment taxes, must be made
under common law rules. Guides for determining the existence of a worker's
status are found in three substantially similar sections of the Employment Tax
Regulations; namely sections 31.3121(d)-1, 31.3306(i)-1, and 31.3401(c)-1
relating to the Federal Insurance Contributions Act (FICA), the Federal
Unemployment Tax Act (FUTA), and federal income tax withholding on wages at
source, respectively.
Section
31.3121(d)–1(c)(2) of the regulations provides that generally, the relationship
of employer and employee exists when the person for whom the services are
performed has the right to control and direct the individual who performs the
services not only as to the results to be accomplished by the work, but also as
to the details and means by which the result is accomplished. That is, an
employee is subject to the will and control of the employer not only as to what
shall be done, but also as to how it shall be done. In this connection, it is
not necessary that the employer actually control or direct the manner in which
services are performed; it is sufficient if he or she has the right to do so.
In general, if an individual is subject to the control or direction of another
merely as to the result to be accomplished and not as to the means and methods
for accomplishing the result, he or she is an independent contractor. Similar
language is found in regulation sections 31.3306(i)–1(b) and 31.3401(c)–1(b).
In determining
whether an individual is an employee under the common law rules, a number of
factors have been identified as indicating whether sufficient control is
present to establish an employer– employee relationship. These factors have
been developed based on an examination of cases and rulings considering whether
an individual is an employee. The degree of importance of each factor varies
depending on the occupation and the factual context in which services are
performed. See Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318 (1992)
and Weber v. Commissioner , 103 T.C. 378 (1994), aff'd 60 F.3d 1104 (4th
Cir. 1995). See also Breaux and Daigle, Inc. v. U. S.. 900 F.2d 49 C.A.5
(La.),1990.
Also see Rev. Rul. 87–41, 1987–1 C.B. 296.
Section
3121(d)–1(a)(3) of the regulations provides that if the relationship of an
employer and employee exists, the designation or description of the parties as
anything other than that of employer and employee is immaterial. Thus, if such
relationship exists, it is of no consequence that the employee is designated as
a partner, co-adventurer, agent, independent contractor, or the like. Similar
language is found in regulation sections 31.3306(i)–l(d) and 31.3401(c)–1(c).
Because there are
elements of controls as well as autonomy in all cases, regardless of whether an
employment relationship or an independent contractor relationship exists, all
evidence of both control and lack of control or autonomy must be evaluated in
determining whether there is a sufficient degree of control to establish an
employment relationship. In doing so, one must examine the relationship of the
worker and the business. Facts which illustrate whether there is a right to
direct or control how the worker performs the specific tasks for which he or
she is hired, whether there is a right to direct or control how the business
aspects of the worker's activities are conducted, and how the parties perceive
their relationship provide evidence of the degree of control and autonomy.
Factors
which influence if a worker is an independent contractor or an employee
include:
Behavioral Control:
Behavioral
control factors establish if an employer can control how a worker performs a
task.
Instructions: Does the
worker perform the required services:
Instruction focuses on how a job gets done and does
not factor in the end result of the job. If a person needs to comply to
instructions about, when, where and how he has to work is ordinarily an
employee. Not all employees need instructions, such as highly proficient
employees. Even with these employees, only the right to enforce instructions
matters, not if the employer actually provides instructions.
(Rev. Rul. 68-598, 1968-2 C.B. 464; Rev. Rul. 66-381, 1966-2 C.B. 449; Silverstone et al. v U.S., USTC 66-1
P 9468.)
Training:
Training
is when methods, procedures or skills need explanation before they are used to
complete a job. This helps complete a job in a particular manner. Factors that
highlight training are required meetings, correspondence or experience
employees working with inexperienced trainees. This training demonstrates an
employer wants control over how a job is done.
Financial Control:
Financial
controls occurs when the company can direct economic aspects of worker’s
activities.
Significant
Investment:
If
an individual has a significant investment in the business, then an independent
contractor relationship may exist. The investment must only have substance; it
does not need to meet any dollar threshold. This investment is seen in the
facilities in which the individual has the investment. A lack of investment in
the facilities will show an employee-employer relationship. Facilities are
equipment or a work premise. These include machinery and office furniture, but
not tools, instruments, clothing, etc.
The
investment is only a significant factor if it is real, essential and adequate.
The investment cannot be in facilities a normal employee will normally maintain
for an employer. Rev. Rul. 71-524, 1971-2 C.B. 346, Avis Rent A
Car System, Inc.
v. U.S. [74-2 USTC, 9725], 503 F2d
423, 429 (2nd Cir. 1974).
Unreimbursed
Expenses:
Unreimbursed
expenses is when a worker incurs their own expenses in relationship with the
job. Having unreimbursed expenses show the worker has the right to direct and
control financial aspects of business operations.
Most
independent contracts incur business expenses. These expenses are either direct
expenses or pro rata portions of several other expense. Typically included in
these expenses are tools, equipment, training, advertising, wages for
assistants, licensing, certification, supplies, travel, leasing equipment and
inventory.
An
employer furnishing tools, materials, etc for a job tends to show an
employee-employer relationship. The control aspects originates in that the
employer can determine which tools a worker uses, in what order and how to use
the tools. Independent contractors normally have their own tools. This is how
the independent contractor may show control. If an employee provides their own
tools in an occupation where this is a customary practice, then such a practice
does not demonstrate lack of control by the employer. Rev. Rul. 71-524, 1971-2
C.B. 346.
When
an employer pays business or traveling expenses for a worker, then the worker
is an employee. Rev. Rul. 55-144, 1955-1 C.B. 483.
Services Available to the Relevant Market:
Independent
contractors can seek their own business opportunities. Doing so incurs expenses
such as advertising and a business location. If a person makes services
available for the public, then they are normally an independent contractor.
(Rev. Rul. 56-660, 1956-2, C.B. 693).
Method
of Payment:
If
a worker is compensated hourly, daily, weekly or in such other similar manner
is guaranteed a return for the labor performed, then this is generally evidence
of an employer-employee relationship. A task for a flat fee, however, tends to
show an independent contractor relationship. Rev. Rul. 74-389, 1974-2 C.B. 330.
Opportunity for Profit or Loss:
A
worker making decisions that affect his own bottom line indicates the presence
of an independent contractor. The ability to affect one’s own bottom line is
not present if the only way to affect the amount of money made is by working
more or less hours. To the contrary, by only affecting the worker’s bottom line
by changing work schedules indicates the presence of an employer/employee
relationship. If the person can receive either a profit or loss due to the
services he performs, then that person is seen as an independent contractor.
Rev. Rul. 70-309, 1970-1 C.B. 199.
Relationship of
Parties:
Intent of Parties through Written
Contracts:
If a contract describes
a worker as an independent contractor, then each party had intent for an
independent contractor relation. This is not sufficient evidence of the
worker’s status. This designation is immaterial and only the substance of the
relationship determines the law. Reg. Sec. 31.3121(d)-1(a)(3)
Employee Benefits:
Any benefits received
by a worker, such as a pension, health insurance, paid sick days can only be
provided to employees, not to independent contractors.
Discharge:
It
is harder for a company to discharge an employee than it is an independent
contractor. This is due to the company being liable for items such as severance
pay and notice. Therefore, the inability to discharge a worker shows the worker
is more likely an employee. However, the right to discharge shows control over
the worker. An independent contractor cannot be discharged unless he produces
at a quality less than contractually agreed. Rev. Rul. 75-41, 1975-1, C.B.323.
Termination:
A
worker may terminate his relationship with an employee usually on an easier
basis. However, an independent contractor cannot merely terminate a
relationship due to a legal obligation to complete the work. Rev. Rul. 70-309,
1970-1, C.B. 199.
Business Activity:
The
services a worker performs and how integral the worker is to the company shows
he is a key aspect to the company. This level of integration into the company
shows the worker is an employee since he is subject to more direction and
control. This test relies on the scope and function of the business and how the
worker functions within it. If the company needs to rely on a person for
company success, then that company will want more direct control over the
individual. U. S.
v. Silk 331 U.S. 704 (1947), 1947-2 C.B. 167.
Miscellaneous Factors to
Consider:
Continuing
Relationship:
A
permanent relationship between the worker and the company is relevant evidence
for an employer-employee relationship. Businesses may engage a worker with the
intent of a continuing relationship instead of a specific project. This shows
intent of an employee-employer relationship. Continuing relationships are shown
through frequent recurring, even if irregular, intervals. U.S. v. Silk, 331 U.S.
704 91947, 1947-2, C.B. 167.
Work
Hours:
If
the employee sets hours a worker must work, then there is control over the
worker. The workers can no longer work as he sees fit but needs to conform to
the employers arrangements. Rev. Rul. 73-591, 1973-2 C.B. 337.
Full
Time:
Working
full time for the business shows the employer has control over the worker
because he restricts access to the worker from finding other employment. Rev. Rul. 56-694, 1956-2 C.B. 694.
