Se habla español!
San Antonio: (210) 223-9389 | Austin: (512) 470-8225

When the IRS Calls . . .

What DO you do when the IRS calls?

The Taxpayer’s Lifeserver is a step-by-step guide to what you can do yourself, and when you need a professional.

Employee or Independent Contractor?

The decision whether or not to treat a worker as an independent contractor rather than an employee has many consequences. Since IRS has a major stake in classifying workers as employees, while the business owner has just as large a stake in classifying them as contractors, many structural variations have been tried by businesses and challenged by IRS. Due to the complexity of the law, this is one area where it’s probably well worth paying to get advice from a qualified CPA or tax lawyer.

Once you have a good understanding of the law, you need to weigh the pros and cons of each choice. Contract labor is a useful way to bring down costs, but it involves giving up control over the workers and in many cases, you can lose the benefits of team work and loyalty.

According to the IRS, the general rule is that an individual is an independent contractor if the employer has the right to control or direct only the result of the work and not the means and methods of accomplishing the results. Independent contractors use their own independent and professional judgment in performing services. Because of the implication of tax liability for the employer, the IRS has established a 20-point checklist (Revenue Ruling 87-41) to determine the status of an independent contractor. However, it is highly controversial and subject to broad interpretation.

The 20 standards used by the IRS to determine the classification of a worker are:

  1. To what degree does the recipient “direct the work?” (Generally, the more detailed the directions, the more likely the worker is an employee and not a contractor.)
  2. Under what conditions can the worker be fired? (An independent contractor should not be fired unless contractual obligations are not met.)
  3. What are the legal obligations of the worker? (An employee may not be legally obligated and not experience any undue repercussions for doing incorrect work or violating company policy or federal, state and local laws, while an independent contractor may incur civil liabilities. The contract would specify the consequences of breach of contract or premature termination.)
  4. Are assistants subject to control by the employer? (Assistants should be employees of the independent contractor, not subject to the employer’s control.)
  5. Is the worker paid per time intervals? (An employee-employer relationship is indicated when workers are paid by the hour, day or week. Independent contractors should be paid on a per job basis.)
  6. Does the employer provide training? (Independent contractors are highly skilled professionals who should possess the expertise needed to do a specific task or project. Employer-provided training indicates an employee relationship.)
  7. Is the worker distinguished from the employer’s regular employees? (An independent contractor should not be doing normal everyday operational duties. Reference to the contract person in the workplace should indicate an independent status.)
  8. Is the work performed characterized by personal service? (The contract should not indicate that the work be performed personally for any specific individual.)
  9. Does the worker provide continuing services for the employer? (Generally, a service performed regularly for the same employer indicates that an employer-employee relationship may exist.)
  10. Are work hours set by the employer? (Scheduling work is a controlled task and indicates an employer-employee relationship.
  11. Does the employer furnish tools? (An independent contractor normally provides the tools necessary to perform contractual services.)
  12. Is the work performed at the employer’s place of business? (Some control is indicated when the worker is near the employer, but it is not concrete. A separate place of business is one characteristic of an independent contractor.)
  13. Has the worker made significant investments in his or her business? (Generally, a business has assets such as facilities, equipment and supplies.) According to the National Association of Temporary Services, contract employment grew 10 times faster than permanent employment from 1982 to 1990, and more than 20 times faster in 1992.
  14. Is the worker required to submit regular reports? (Regular reporting by the worker is evidence of control. This does not preclude a final report at the conclusion of the project.)
  15. Does the worker devote full time to one employer? (An independent contractor should offer services to multiple clients. Too much concentration on the work of one employer may create a dependence and lead to control by the employer.)
  16. Does the employer designate the order or sequence of work to be performed? (The employer can specify the output, but should not be able to direct or control how an independent contractor does the job.)
  17. Does the employer of the services pay business and traveling expenses? (Whenever possible, the cost of expenses should be covered by the contract. The payment of expenses outside of the contract’s scope may be construed as employee expenses.)
  18. Is the worker exposed to normal profit and loss risks associated with operating a business? (If there is evidence that the worker is subject to both suffering losses and reaping profits on a project or job, then the worker is operating a business and is an independent contractor.)
  19. Does the worker provide services to the general public? (An employer-employee relationship exists when the worker performs services exclusively for one employer. Working for multiple clients demonstrates that the worker is operating an independent trade or business.)
  20. Does the worker provide services to more than one employer? (The contract between employer and the worker does not restrict the worker from offering his or her services to other parties.)

Three additional factors that have been considered by the courts to determine worker status include the following: 1) the level of skill required by the worker, 2) the intent of the parties and 3) the prevailing industry practice.

Section 530 of the 1978 Revenue Act provides companies relief from retroactive reclassification by the IRS. An organization can receive relief if it: 1) did not treat the worker as an employee for any period, 2) filed all necessary tax forms consistent with its treatment of the worker and 3) had a “reasonable basis” for treating the worker as an independent contractor. A reasonable basis means that an organization relied on a judicial precedent, technical advice memorandum, private letter ruling or determination letter; had a prior audit that did not result in assessing employment taxes due to the firm’s treatment of workers as independent contractors; or relied on long-standing industry practices within which it operates.