The distinction between treating someone as an employee instead of an independent contractor is significant.
For an independent contractor, for example, nothing is withheld from the payments made to the independent contractor for a number of payroll related taxes that would otherwise have been withheld if the payee had been treated as an employee. Within the employer/employee relationship, the employer is liable and responsible for paying for a variety of payroll related taxes such as Social Security and unemployment tax that are avoided by treating the payee as an independent contractor.
The bottom-line is that if a payee is treated as an independent contractor instead of as an employee, the payer avoids having to pay as much in taxes.
To assist in the determination of whether a payee is an employee or independent contractor, the IRS developed what is referred to as the “20 Factor Test.” The test lists 20 different factors or questions under the common law that, depending on the circumstances at hand, provides some indication of whether the payee is an employee or independent contractor. The thrust of the test attempts to determine and evaluate the degree of control and degree of independence that the payer has over the payee. If the degree of control and independence that the payer has over the payee is significant enough, then the payee is more likely to be determined to be an employee.
The following “20 Factor Test” comes from IRS 87-41.
Instructions. An employee must comply with instructions about when, where and how to work. The control factor is present if the employer has the right to require compliance with the instructions.
Training. An employee receives on-going training from, or at the direction of, the employer.
Independent contractors use their own methods and receive no training from the purchasers of their services.
Integration. An employee’s services are integrated into the business operations because the services are important to the business. This shows that the worker is subject to direction and control of the employer.
Services rendered personally. If the services must be rendered personally, then presumably the employer is interested in the methods used to accomplish the work as well as the end results. An employee often does not have the ability to assign their work to other employees; an independent contractor may assign the work to others.
Hiring, supervising and paying assistants. If an employer hires, supervises and pays assistants, the worker is generally categorized as an employee. An independent contractor hires, supervises and pays assistants under a contract that requires him or her to provide materials and labor and to be responsible only for the result.
Continuing relationship. A continuing relationship between the worker and the employer indicates that an employer-employee relationship exists. The IRS has found that a continuing relationship may exist where work is performed at frequently recurring intervals, even if the intervals are irregular.
Set hours of work. A worker who has set hours of work established by an employer is generally an employee. An independent contractor sets his/her own schedule.
Full-time required. An employee normally works full-time for an employer. An independent contractor is free to work when and for whom he or she chooses.
Work done on premises. Work performed on the premises of the employer for whom the services are performed suggests employer control, and therefore, the worker may be an employee. An independent contractor may perform the work wherever they desire as long as the contract requirements are performed.
Order or sequence set. A worker who must perform services in the order or sequence set by an employer is generally an employee. Independent contractor performs the work in whatever order or sequence they may desire.
Oral or written reports. A requirement that the worker submit regular or written reports to the employer indicates a degree of control by the employer.
Payments by hour, week or month. Payments by the hour, week or month generally point to an employer-employee relationship.
Payment of expenses. If the employer ordinarily pays the worker’s business and/or travel expenses, the worker is ordinarily an employee.
Furnishing of tools and materials. If the employer furnishes significant tools, materials and other equipment by an employer, the worker is generally an employee.
Significant investment. If a worker has a significant investment in the facilities where the worker performs services, the worker may be an independent contractor.
Profit or loss. If the worker can make a profit or suffer a loss, the worker may be an independent contractor. Employees are typically paid for their time and labor and have no liability for business expenses.
Working for more than one firm at a time. If a worker performs services for a multiple of unrelated firms at the same time, the worker may be an independent contractor.
Making services available to the general public. If a worker makes his or her services available to the general public on a regular and consistent basis, the worker may be an independent contractor.
Right to discharge. The employer’s right to discharge a worker is a factor indicating that the worker is an employee.
Right to terminate. If the worker can quit work at any time without incurring liability, the worker is generally an employee.
Furthermore, facts falling within the following three categories are to be evaluated in conjunction with the “20 Factor Test.” These facts will provide evidence of the extent or degree of control and independence that exists between the payer and payee.
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? (These include things like how the worker is paid, whether expenses are 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 performed a key aspect of the business?
The IRS states the following:
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.
There is no “magic” or set number of factors that define the worker to be an employee or an independent contractor, and no one factor can make this determination.
Also, factors that are relevant in one situation may not be relevant in another.
Statutory Employees or Independent Contractors
The Internal Revenue Code contains various provisions that prescribe treatment of a specific category or type of worker as an employee or an independent contractor. These provisions override whatever other determinations are made under the common law.
For example, for federal tax purposes certain real estate agents and direct sellers are treated for all tax purposes as not being employees. Others apply only for specific purposes; for example, full-time life insurance salespersons are treated as employees for social security tax and employee benefit purposes while certain salespeople are treated as employees for social security tax purposes, as the IRS notes.
Do you have the support you need to manage your small business bookkeeping?
Contact us to schedule an appointment to speak with a local small business advisor.