As far as the IRS is concerned, there are only two types of workers in the world: employees and independent contractors ("ICs"). Independent contractors are people who are in business for themselves. Employees work for someone else’s business. Being classified as an independent contractor instead of an employee has enormous consequences. Because they are supposed to be in business for themselves, ICs don't get the same legal protections that employees do--for example, they don't qualify for unemployment insurance and are not protected under most labor laws. Moreover, hiring firms need not provide ICs with benefits ordinarily provided to employees such as health insurance or vacations.
Initially, it’s up to the hiring firm to determine whether any person it hires is an employee or an IC. Unfortunately, because independent contractors often cost less than employees, some employers classify their workers as contractors even though they are really employees. In fact, the Labor Department estimates that up to 30% of companies misclassify employees. The IRS considers worker misclassification to be a serious problem that costs the U.S. government billions of dollars in taxes that would otherwise be paid if the workers were classified as employees and taxes were automatically withheld from their paychecks. Most state agencies live by the same theory.
A hiring firm's decision about how to classify a worker is subject to review by various government agencies, including:
- the IRS
- the state tax department
- the state unemployment compensation insurance agency, and
- the state’s workers’ compensation insurance agency.
If the IRS or other government agency determines that a hiring firm has misclassified an employee as an IC, it can order the firm to treat the worker as an employee and require it to pay back taxes and substantial penalties. Being reclassified is not necessarily great for the worker either--he or she could lose valuable business tax deductions.
It can be difficult to determine whether a worker is an employee or IC. There is not a precise test. The IRS and many other government agencies use the “right of control” test to determine whether a worker is an employee or independent contractor. The determining factor is usually whether the hiring firm has the right to control the worker. If it has the right to direct and control the way the worker performs—both as to the final results and the details of when, where, and how the work is done—then the worker is an employee. On the other hand, if the hiring firm's control is limited to accepting or rejecting the final results the worker achieves, then that person is an IC.
An employer may not always exercise its right of control. For example, if an employee is experienced and well trained, the employer may not feel the need to closely supervise him or her. But the employer still maintains the right to do so at any time.
The difficulty in applying the right of control test is that control isn’t always easy to determine. Government auditors can’t look into a hiring firm's mind to see if it is controlling a worker. They rely instead on indirect or circumstantial evidence indicating control or lack of it—for example, whether the hiring firm provides the worker with tools and equipment, where the work is performed, how the worker is paid, and whether the worker can be fired.
The following chart shows the primary factors used by the IRS and most other government agencies to determine if you have the right to control a worker.
IRS TEST FOR WORKER STATUS
Workers will more likely be considered ICs if hiring firm:
does not give them instructions
does not provide them with training
Workers will more likely be considered employees if hiring firm:
gives them instructions they must follow about how to do the work
gives them detailed training
Workers will more likely be considered ICs if they:
have a significant investment in equipment and facilities
pay business or travel expenses themselves
make their services available to the public
are paid by the job
have opportunity for profit or loss
Workers will more likely be considered employees if:
hiring firm provides them with equipment and facilities free of charge
hiring firm reimburses their business or travel expenses
they make no effort to market their services to the public
hiring firm pays them by the hour or other unit of time
they have no opportunity for profit or loss—for example, because they’re paid by the hour and have all expenses reimbursed
Relationship Between Hiring Firm and the Worker
Workers will more likely be considered ICs if:
they don’t receive employee benefits such as health insurance
they sign a client agreement with the hiring firm
they can’t quit or be fired at will
they perform services that are not part of hiring firm's regular business activities
Workers will more likely be considered employees if they:
receive employee benefits
have no written client agreement
can quit at any time without incurring any liability to hiring firm
can be fired at any time
perform services that are part of hiring firm's core business