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Employee v. Independent Contractor: The IRS’ 20-Factor Test Analyzed

Employment taxes are expensive. Payroll taxes are expensive. Withholding taxes is an administrative burden. All true. But I remember a wise tax lawyer once saying to a group of us, “if you can’t afford to pay employment taxes, your business isn’t making enough money.”

The IRS is an interesting governmental authority. So are state taxing authorities. These entities feel faceless but threatening. You hear from them by letter only, and cringe when you see the envelopes. The language is foreign, dry, and arithmetically driven.

But legal compliance needn’t be that scary, so long as you’re armed with the basic knowledge to do the right thing. We are, after all, governed by the adage, “ignorance of the law is no excuse.”

Let’s take a quick look at the problem of worker classification. Then I’ll outline a comprehensive overview of the factors that dictate proper classification. Of course, I invite you to contact me directly if you’d like to discuss this topic.

The Dark Side of Misclassifying Employees as Independent Contractors

It isn’t surprising that millions of businesses skirt these expensive taxes by misclassifying workers. Some studies show that up to 30% (or more) of American businesses misclassify their workers. But doing so denies millions of people of workplace-protection laws (i.e. minimum wage, overtime, and contributions to social security); It deprives unemployment insurance and workers’ compensation funds of billions of much-needed dollars; And of course, it reduces federal, state and local tax withholding and revenues.

Research further shows that misclassification impacts hardest poorer minorities and immigrants. To add insult to injury, these workers are denied protection from discriminatory practices.

The problem seems to be getting worse. Employee misclassification perseveres in many of our economy’s growth industries, including home care, personal services, delivery, construction janitorial, trucking, hospitality, restaurants, and more recently, in rapidly growing app-dispatched jobs.

Economic penalties for misclassification, if caught, can be ruinous. To the employer, such consequences may include liability for withholding taxes for a number of years, interest and penalties, and potential disqualification from employee benefit plans. To the worker, such consequences may include liability for self-employment taxes and denial of certain business-related deductions.

The government is not treating this problem lightly. The IRS prosecutes these investigations using an Employment Tax Specialty Group. State-level task forces, commissions, and research teams are using agency audits along with unemployment insurance and workers’ compensation data to understand the scope of independent contractor misclassification.

Before we dig in to the “20-Factor Test,” it’s important to understand the three overriding elements of the control test, which underpins the 20-Factor Test.

The Control Test

Generally, at issue is whether the business has the right to direct or control the worker who performs the services. This means that the employer has the right to control the result, the means, and the detail of the work. The employer need not actually direct or control the work, but just have the right to do so. As with many tax scenarios, the “facts and circumstances” are always core to the examination.

The Three Elements of The Control Test:

Behavioral Control:

  • Does the business train, supervises, and/or instruct the worker?
  • To what degree may an employer intervene to impose control?
  • Are time limits imposed?
  • What are the details of the instruction, and what are the consequences for noncompliance?

Financial Control:

  • Does the worker treat her services as an independent business?
  • Does the worker have a significant investment?
  • Is the worker available to the market at large?
  • Is the worker paid by the hour or by project?
  • Does the worker have the opportunity for profit or loss?

Relationship of the Parties:

  • Is there an agreement that reflects the intent for control or autonomy?
  • How do the parties perceive their relationship?
  • What does the business do, and how does the job actually get done?

The IRS’ 20-Factor Test for Worker Classification

  1. Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
  2. Training: Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
  3. Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
  4. Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
  5. Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee 3 Treas. Reg. sec. 31.3401(c)-(1)(b). 4 Id. See also, Gierek v. Commissioner, 66 T.C.M. 1866 (1993) (involving the classification of a stockbroker and stating that the key inquiry is whether the brokerage firm had a right to control the worker regardless of the extent to which such control was actually exercised). See also, IRS Publication 1779 (Rev. 1-2005). 5 Rev. Rul. 87-41, 1987-1 C.B. 296 (providing guidance with respect to section 530 of the Revenue Act of 1978). 4 status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
  6. Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
  7. Set hours of work: The establishment of set hours for the worker indicates employee status.
  8. Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
  9. Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
  10. Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
  11. Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
  12. Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
  13. Payment of business and/or traveling expenses. If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
  14. Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
  15. Significant investment: Investment in facilities used by the worker indicates independent contractor status.
  16. Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
  17. Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status. 5
  18. Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
  19. Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
  20. Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.

Potential Relief from Worker Misclassification

Businesses may claim anticipated relief under Section 530 of Publication 1976. This is a “safe harbor” provision that relieves employers from liability who had a reasonable basis for misclassifying a worker. This provision only grants relief for employment taxes—not income taxes. Confusingly, this relief is not codified in the Internal Revenue Code. The IRS is instructed to explore the possibility of this relief even if the business doesn’t.

If the below three elements are met, the employer (not the employee) may be relieved from employment tax liability including interest and penalties for employment liabilities.

  1. Reporting consistency: If you’ve classified workers as independent contractors, you’ve timely filed all 1099’s consistently.
  1. Substantive consistency: You’re treating and classifying all similarly situated workers the same.
  1. Reasonable Basis: You relied on something reasonable to guide your classification decision. Whether it be a court case, and IRS position, your industry commonplace, advice from a lawyer or accountant.

Five Additional Resources to Remedy your Misclassification

  1. Here is the 160-page behemoth training manual written by the Department of Treasure. It’s called, Independent Contractor or Employee? Training Materials.
  2. You may complete IRS Form SS-8 to invoke the IRS’ ruling as to whether or not you’ve made the right decision on classification. Note: It may take 6 months or more to get an IRS response. This strategy seems like a smart—albeit scary bet—since the IRS’s weighing of factors and conclusions may depart from yours.
  3. A previous blog I wrote, Who is Liable for Employment Taxes in the Wake of Covid-19 Business Closures?
  4. For knowingly misclassified workers, you may apply, using Form 8952, for Voluntary Classification Settlement Program (VCSP). If you’re eligible, you could reclassify workers for future tax periods and obtain partial relief from federal employment taxes owed. Partial relief of federal employment taxes, according to the IRS website, would require payment of “10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of section 3509(a).”
  5. Guidelines for determining a worker’s employment status are found in three tax regulations: Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and federal tax withholding. The “who are employees” regulation is found here. These guidelines incorporate the common-law test of agency and inquires as to whether the worker “is subject to the will and control of the employer not only as to what shall be done but how it shall be done.

I hope that this information helped you become more keenly aware of your employment and business obligations. Feel free to contact me to discuss this important topic.