For the first time in twenty-five years, the IRS began a comprehensive audit of employment tax issues last month.   This newly-initiated audit will transpire over a three-year period and when completed, will affect over 6,000 companies across the country.  Although we understand that the main issues to be examined are worker classification, executive compensation, and taxable fringe benefits; we anticipate that worker classification will undergo the most scrutiny.  Accordingly, we focus here solely on worker classification and the factors the IRS will consider in evaluating whether an accurate classification was made.

An effective worker classification analysis should begin with answering the following two threshold type questions:

• Does the company pay one or more employees to perform essentially the same duties as the subject worker who is treated as an independent contractor?
• Has the subject worker previously been paid by the company as an employee to perform essentially the same task?

If the answer to either of these questions is yes, the worker most likely will be deemed an employee for classification purposes.

Beyond these threshold questions, fundamentally, the IRS will allow independent contractor classifications only when the company hiring the contractor can show that it lacks the necessary control over the worker that otherwise would indicate an employer-employee relationship.  As part of the audit, therefore, the IRS will consider the following 20 factors in order to determine whether the company has “control” over the worker or workers in question:

1. Instructions. A worker who is required to comply with another person’s instructions re: when, where, and how to perform work is likely an employee.
2. Training. Training a worker indicates that the company wants the services performed in a particular method or manner, which indicates control.
3. Integration. Integration of the worker’s services into the company’s core business operations suggests that the worker is subject to direction/control.
4. Services Rendered Personally.  Where a worker must personally perform services for the company, control by the company is indicated. Alternatively, if a worker is free to engage others to perform the service for the company (i.e., subcontractors), lack of control is indicated.
5. Hiring, Supervising and Paying Assistants. If the worker is unable to hire, supervise, and pay assistants to perform services for the company in the worker’s stead, control is indicated. By contrast, a lack of control is indicated when the worker is able to hire his/her own assistants and pay them from his/her own funds.
6. Continuing Relationship. A lengthy and continuous relationship between the worker and company suggests an employment relationship.
7. Set Hours of Work. If the worker works certain hours set by the company, employment status is indicated. Where hours are not controlled or set by the company, independent contractor status is indicated.
8. Full Time Required. If the worker must devote substantially full-time to the company’s business, control is indicated.
9. Work Performed on Employer’s Premises. If the work is performed on the company’s premises, the company is considered to have control, especially if the work could be done elsewhere. Control is also indicated when the company has the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places.
10. Order or Sequence Set. If a worker must perform services in the order or sequence as determined by the company, the worker is generally subject to an employer’s control. But if the worker chooses his/her own method for completing a job, a lack of control exists.
11. Oral or Written Reports. A requirement that a worker submit regular or written reports is an indicator of control.
12. Payment by Hour, Week, Month. Hourly, weekly or monthly payments generally point to an employment relationship. On the other hand, payments based on a contract or for completing a particular job or task will generally indicate an independent contractor relationship.
13. Payment of Business and/or Traveling Expenses. If the company ordinarily pays the worker’s business and traveling expenses, the worker is ordinarily an employee.
14. Furnishing of Tools and Materials. If the company furnishes significant tools, materials, or other equipment, an employment relationship is indicated.
15. Significant Investment. If the worker does not invest in his/her own facilities, control is indicated because the worker depends on the company.
16. Realization of Profit or Loss. A worker who cannot realize a profit beyond an ordinary salary or suffer a loss is generally considered an employee.
17. Working for More Than One Firm at a Time. If the worker cannot perform services for more than one company at a time, the company generally controls the worker. A lack of control, however, is indicated when the worker is allowed to perform services for multiple companies simultaneously.
18. Making Service Available to General Public. If a worker is not free to advertise his or her services to the general public on a regular basis, control is indicated. Workers who advertise their services are generally considered independent contractors.
19. Right to Discharge. The right of the company to discharge a worker without breaching a contract indicates an employment relationship as control is exercised through the threat of dismissal.
20. Right to Terminate. If the worker has the right to end his or her relationship with the company at any time without incurring liability, an employment relationship is indicated.

See Rev. Rul. 87-41;  see also IRS Form SS-8. None of these factors are singularly determinative. Instead, all factors should be considered in making an accurate determination.

It is important to understand that the various state revenue and labor departments are also concerned with worker misclassification and have been increasing enforcement over classification at varying speeds. The worker classification analysis used by many states will differ substantially from the 20-factor test used by the IRS.  This means that different classifications can result based on the same facts.  Accordingly, the IRS could, for example, determine that a worker is rightfully classified as an employee when another agency could determine that that same employee should be classified as an independent consultant.

If your company uses independent contractors and you have classification questions after reviewing this 20-factor test, either at the federal or state level, please contact The AR Group at info@theARgroup.com or 720-283-1021.  We specialize in conducting attorney-client-protected audits and devising corrective strategies.

Tagged: independent contractor; employee classification; IRS