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Independent Contractor Versus Employee

Worker classification is one of the most contentious issues between the IRS and employers and is now purported to be an area of emphasis for IRS auditors in 2009.

December 8, 2008
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Worker classification is one of the most contentious issues between the IRS and employers and is now purported to be an area of emphasis for IRS auditors in 2009. Failure to properly classify workers can be a costly error when the IRS comes knocking.

An employer has a bias towards treating a worker as a contractor rather than an employee in order to shift the employment tax burden to the worker, exclude the worker from fringe benefit programs, and minimize the administrative burden of payroll tax returns. Before you classify that worker as a contractor you should use the following test and factors to be sure that you classify them correctly.

The Common Law Test

The status of an individual for federal employment tax purposes is determined in accordance with certain common law rules. Status guidelines are set forth in three substantially similar sections of Regs. 31.3121(d), 31.3306(i)-1, and 31.3401(c)-1. These regulations provide 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 result to be accomplished, but also as to the details and means by which that result is accomplished. It isn’t necessary that the employer actually direct or control the manner in which the services are performed as long as he or she has the right to do so.

The IRS 20 Factors

As an aid to worker classification under the common law rules the IRS has identified 20 factors that indicate whether sufficient control is present to establish an employer-employee relationship.

Although no single factor is determinative of a worker’s classification, several of the 20 carry more weight than the others. Answering yes to one or more of the following questions may mean that an employee-employer relation exists.

Instructions. Does the person for whom the services are performed have a right to require compliance with their instructions?

Integration. Is the worker’s services integrated into the operations of the business?

Continuing Relationship. Is there a continuing relationship between the worker and the person for whom the services are performed?

Significant Investment. Is there a lack of investment in facilities and/or assets used in performing the services on the part of the worker?

Realization of Profit or Loss. Is the worker unable to realize a profit or loss (in addition to the profit or loss ordinarily realized by an employee)?

Right to Discharge. Does the person for whom the services are performed have the right to discharge the worker?

The Consequences. The incorrect classification of workers as contractors rather than employees can result in significant adverse consequences in addition to delinquent payroll taxes.

Now is a good time to review the status of all your workers to be sure they are properly classified. Use the Common Law test along with the IRS 20 factors to ensure that you have correctly classified your workers; letting the IRS make that review can result in some very unpleasant surprises.

From the CPE & Training Solutions Monthly e-newsletter from the Tax & Accounting business of Thomson Reuters, November 2008. To subscribe to this free, informative newsletter, visit trainingcpe.thomson.com or click here.