often prefer to treat workers as independent
contractors to lower their costs and administrative
burdens. But the IRS, the U.S. Department of Labor,
various state agencies or even the employees
themselves may challenge an employer's
classification. The U.S. Tax Court considers seven
factors when deciding whether to classify workers as
employees or independent contractors. But states
have their own tests for determining employee
make things more understandable, we will call
businesses that hire workers "employers" (whether
the workers are employees or independent
contractors), and we'll call the individuals who get
the job done "workers" (whether they're employees or
Common-Law Employee vs. Independent Contractor
Common-law employees are workers considered to be
employees (as opposed to independent contractors)
based on various statutes, regulations and court
decisions. IRS and DOL rules can differ from state
and local rules. That said, if an employer is
allowed to treat a worker as an independent
contractor under IRS rules, it will generally be the
same across the board. But not always as the recent
FedEx cases demonstrate (see the right-hand box).
Properly classifying a worker as an independent
contractor is beneficial because the employer
doesn't have to worry about employment tax issues or
provide expensive fringe benefits.
However, when an employer mistakenly treats an
employee as an independent contractor, the employer
could owe unpaid employment taxes, as well as
interest and penalties. The employer also may be
liable for employee benefits that should have been
provided but were not. So, it's important to get
worker classification questions right.
Seven Factors to Decide Worker Classification
The Tax Court considers these factors when deciding
whether workers should be classified as independent
contractors or employees for federal employment tax
1. Degree of Control. When
an employer exercises significant control over how a
worker performs duties or has the right to do so,
this factor indicates employee status. When there's
little or no control or right to exercise it, this
factor indicates independent contractor status.
2. Investment in Equipment and Facilities. When
the worker covers most or all of the cost of
equipment and facilities used for the job, this
factor indicates independent contractor status. For
example, say the worker performs his duties out of
an office in his home using equipment (computer,
printer and phone) that he pays for himself. In such
a case, this factor would clearly indicate
independent contractor status. On the other hand, if
the employer provides most or all of the equipment
and facilities, this factor would indicate employee
3. Whether the Worker Has an Opportunity for
Open-Ended Profit or Outright Loss. A
worker who can make an open-ended profit through the
strength of his or her own efforts or,
alternatively, can suffer an outright loss on the
job, is likely to be an independent contractor
rather than an employee. For example, this would be
the case when an outside sales person is paid by
On the other hand, when the compensation arrangement
dictates that the worker can only make a fixed
profit and not suffer a loss, it indicates employee
status. For example, this would be the case when the
worker is paid a fixed amount for each day of work
and the only significant job-related expense is the
cost of commuting to and from the work site.
4. Whether the Worker Can Be Discharged. A
worker who can be discharged is more likely to be an
employee than an independent contractor.
5. Whether Work Is Related to Employer's Core
the worker's duties relate to the employer's core
business it indicates employee status, while work
related to a tangential enterprise indicates
independent contractor status.
6. Permanency of Relationship Between the Employer
and Worker. Lack
of permanency indicates independent contractor
status while permanency indicates employee status.
7. Relationship the Employer and Worker Believed
they Were Creating. If
the employer and the worker believed the same thing
at the time they entered into their arrangement,
courts rule this factor can indicate either employee
or independent contractor status, depending on the
facts. If the parties believed two different things,
this factor may be thrown out.
A Closer Look at Degree of Control
Based on longstanding tradition, the degree of
control is the most important of the seven factors
the Tax Court uses to decide whether a worker is an
employee or independent contractor. It's often used
as the tie-breaker in situations where there are an
equal number of factors on both sides.
The IRS has developed a 20-factor control test based
on common law principles that have evolved in the
courts. The following factors are used to determine
the degree of control an employer has over the
worker in order to establish an employer-employee
Employer provides instructions to worker.
Employer provides training to worker.
Worker is integrated into business operations.
Employer requires the services be rendered
personally by the worker.
Employer hires, supervises and pays the worker's
The relationship between the employer and worker is
continuous (or permanent).
Employer sets the hours of work.
Employer requires full-time work.
Work is performed on employer's premises.
Employer sets the order or sequence of work.
Employer requires oral or written reports from the
Employer pays worker by the hour or week.
Employer pays worker's business and/or traveling
Employer furnishes worker's tools and materials.
Worker is not required to make a significant
Worker does not realize profit or loss.
Worker does not perform services for more than one
business at a time.
Worker's services are not available to the general
Employer has the right to discharge worker.
Worker has the right to terminate relationship.
To the extent that these factors are present, the
employer has control over the worker. The higher the
degree of control, the more likely it is that the
IRS will classify a worker as employee, not an
Why Worker Classification Matters
When a worker is properly classified as a common-law
employee, the employer generally must withhold
federal income and employment taxes from the
worker's wages. The employer must also comply with
various IRS and Department of Labor (DOL) rules and
In addition, the employer may have to deal with
state and local income tax withholding, pay state
unemployment and workers' compensation taxes, and
comply with even more local rules and regulations.
Handling all of this red tape can cost a bundle
every year for each employee. If employee benefits
-- such as health insurance, paid vacations, and
sick leave -- are also provided, the cost of keeping
a common-law employee on the payroll can become
In contrast, when a worker is properly classified as
an independent contractor, the employer must simply
provide the worker and the IRS with a Form 1099-MISC
each year to report how much the worker was paid.
That's why many businesses prefer to treat as many
workers as possible as independent contractors
instead of employees.
It's important to properly set up employment status
from the get-go to avoid government audits,
enforcement actions and lawsuits. An experienced tax
adviser knows the ins and outs of worker
classification and can help employers toe the fine
line between employee and independent contractor
status for their workers.
For more information, call Boris Benic at 516-248-7361 or click
here to email Boris Benic.
Thomson Reuters/Tax & Accounting