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The Issue around the IRS, Employees and Independent Contractors

It is critical that, as a small business owner, you correctly classify the people working as either employees or independent contractors. The IRS takes a dim view of companies who masquerade employees as independent contractors.

For federal tax purposes (individual states’ requirements are outside the scope of this article), there are “common law rules” that apply in order to determine whether the worker is an independent contractor or an employee. Under common-law rules, anyone who performs services for you is an employee if you can control

  • what will be done
  • how it will be done

This is the case even if you give the person the freedom to handle the task/job as she desires. It does not matter if they actually manage their project in that manner; it just matters that you have stated that it is your right to control the details of how the tasks/services are performed.

Common Law Factors
All evidence of the degree of control you have has to be considered. The factors that you must consider fall into three categories:

  1. Behavioral – facts that show whether the business has the right to direct and control how the worker performs the job that they have been contracted to do. This includes:
    • Instructions that have been given to the worker, including where and when to do the work, whether assistants can be hired, order or sequence to follow, where to purchase supplies, etc.
    • Training that may or may not have been given to the worker.
  2. Financial – facts that show whether the business has the right to direct or control the financial aspects of the worker’s job. This can include:
    • The reimbursement for business expenses.
    • The investment provided in tools/facilities when performing the job tasks.
    • Whether or not the worker’s services are made available to “a relevant market”
    • How the worker is paid.
    • The degree to which the worker can realize a profit or incur a loss.
  3. Type of Relationship – facts that show what type of relationship exists between the business and the worker. Is there:
    • A benefits package provided to the worker?
    • A written contract describing the relationship that you and the worker intend to create?
    • A level of permanency in the relationship?
    • An understanding that the tasks provided are crucial to your primary line of business?

These factors can vary, and there is no set number of factors (or single factor, for that matter) that defines a particular worker as an employee or independent contractor. In addition, factors which are relevant in one situation may not be relevant in another.

You will need to

  • look at the entire relationship
  • consider the degree or extent of the right to direct and control
  • document each of the factors used in coming up with your determination.

Get Help, If You Need It
If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, the business (or the worker) can request that the IRS review all the facts and officially determine the worker’s status. Submit a free streamlined ruling form – Form SS-8,

Be aware a ruling can take at least six months to get a determination, and the answer may not be to your liking. According to Forbes magazine, 72% of Form SS-8 rulings come back as an “employee determination”. Twenty-five percent were closed without a ruling and only 3% of the rulings were as an “independent contractor determination”.