A big issue facing business owners today is determining if an individual should be hired as an employee or as an independent contractor. The government does not take this issue lightly. Misclassifying workers as independent contractors can result in large, unexpected tax bills along with penalties and interest. Furthermore, employers may pay penalties on employment taxes – Social Security, Medicare, and Federal and State Unemployment – in addition to incorrectly filing tax forms. Determining the correct classification requires an in-depth look at the circumstances surrounding the worker’s arrangements.
According to the IRS, employees are workers over which the business may legally control and direct both (1) what must be done, and (2) how it must be done. Independent contractors are workers over whom the business may legally control and direct only what must be done. With an independent contractor, there is no control on how, when or where the work is. Under the common law, you must examine all evidence to determine if a worker will be an employee or an independent contractor. The IRS created a 20 Factor Test to help guide your decision on the worker’s status. The 20 Factor Test is broken down into three categories – Behavioral Control, Financial Control, and the Relationship of the Parties.
The Behavioral control test determines if the company has the right to direct or control how the work is done. With an employee, this is done through extensive instructions. For example, the company would decide how, when or where to do the work. This test may also help decide what tools or equipment this individual will use and if an assistant should help with the work. An individual is also considered an employee if the company decides what training he or she should attend. An independent contractor will receive less extensive instructions and there will be no mention of how the work should be done.
The Financial control test determines if an individual has a significant investment with the work being performed. There is not an actual monetary value with this test, but if it is “significant” then the individual is more likely to be classified as an independent contractor. Also, if the individual is not reimbursed on the majority of business expenses incurred with the work, then the individual will more likely be an independent contractor. Along with paying for their own business expenses, independent contractors experience an actual profit or loss suggesting that they are in business for themselves.
The Relationship control test determines if there is a relationship between the individual and the business that would result in the individual being classified as an employee. The relationship could consist of receiving benefits, such as pension, insurance, vacation pay or paid time off. According to the IRS, if the business expects the relationship to continue indefinitely, rather than for a specific project or period, then this is evidence that the intent was to create an employer-employee relationship. A contract stating if the individual is an employee or an independent contractor is not something the IRS will regard as proof of status. However, including in a contract the specific details on how the parties will work together will be more significant to the IRS if needed.
Even though the federal government has created the 20 Factor Test, classifying between independent contractor and employee varies by state as well. In Illinois, each governmental agency has its own interpretation of how they classify a worker. The Illinois Department of Employment Security (IDES) has the “ABC” test which is a three part test, very similar to the IRS test. In some cases IDES only focuses on one part of the test and will classify a worker as an employee if they only work for one company and do not actively advertise or offer services to other companies. The Illinois Department of Labor (IDOL) enforces the Illinois Employee Classification Act, which focuses on misclassification in the construction industry. Depending on the industry, there can be exceptions to these rules or the enforcing department may create more detailed rules.
Even after going through the numerous checklists, the answer may not be that clear. In these cases it may be helpful to file form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” with the IRS. Based on the facts and circumstances provided, the IRS will make a determination on whether the individual is an employee or an independent contractor. This can be a long process (up to 6 months) but it may be valuable to companies who consistently hire the same type of worker. Companies who utilize a large number of contractors may find it necessary to hire an expert and/or conduct their own internal audits to confirm all workers are classified correctly before the government contacts them.
Taking the time to review worker classifications, namely the three steps posted by the IRS can prove valuable to you and your business. The rules can be complex and in some cases contradictory between the government agencies. Therefore, I suggest documenting your criteria and following it consistently as it can prove extremely valuable in the event of an examination. If you have any questions or would like help developing a Worker Classification Policy for your Company, email or call Apex CPAs and Consultants at (630) 584-4555.
— Erin Triolo, Enterprise Division Associate II