The distinction between an employee versus an independent contractor has grown harder to identify in the past decade. But it is critical for business owners to understand the difference in this classification, as a misclassification can result in a liability for back employment taxes, penalties and interest, and even potential disqualification of employee benefit plans.
The definition of who is considered an employee has been codified. The Internal Revenue Code and underlying regulations refer to the common law definition of an employee. Past case law and IRS examinations and rulings have assisted taxpayers to understand that an employment relationship exists if the person providing the service is subject to the control of the employer as to what should be done and how it should be done.
In 1987, the IRS further attempted to assist taxpayers by developing a list of 20 factors that could be reviewed and used to determine whether a worker is an employee. The 20 factor test consisted of whether the business provided training, instructions, and a work schedule for the worker. It also looked at the continuing relationship between the worker and the business as well as a number of other criteria.
Over the past several years, the IRS has used more recent case law to develop a three-category approach to assist in classifying a worker as an employee or as an independent contractor. The three categories are behavioral control, financial control, and relationship of the parties.
Behavioral Control covers whether the business has a right to direct and control what work is accomplished and how the work is done through instructions, training, or other means.
Financial Control covers whether the business has a right to direct or control the financial and business aspects of the worker's job. This includes:
- The extent to which the worker has unreimbursed business expenses,
- The extent of the worker's investment in the facilities or tools used in performing his or her services,
- The extent to which the worker makes his or her services available to the relevant market,
- How the business pays the worker, and
- The extent to which the worker can realize a profit or incur a loss.
Relationship of the Parties covers the type of relationship the business and worker have. This includes:
- Written contracts describing the relationship the parties intended to create,
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay,
- The permanency of the relationship, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company.
The decision to classify a worker as an employee or an independent contractor is a gray area. It is imperative that business owners take a step back and evaluate all of the facts when making this decision.
Brian D. Kitchen can be reached at Email or 215.441.4600.
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