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Employee
or Independent Contractor?
Not knowing the
difference can prove costly to you!
Many employers erroneously think that they can "hire" individuals as
independent contractors simply by having them agree to work under that
designation, orally or in writing in the form of a contract.
Nothing could be further from the truth. There are specific
criteria established in Revenue Ruling 87-41 for determining whether
one employed is an employee or an independent contractor, leaving the
burden of proof encumbent upon the employer to substantiate the
worker's status as an independent contractor. Commonly known as
the "Twenty Factor Test", these criteria should be reviewed by every
employer whenever there is a question regarding a worker's status as an
independent contractor or as an employee: the penalties for
failing to do so can be severe, including back federal and state
employment and income taxes, interest, and thousands of dollars in
penalties. Some employers mistakenly think that the Internal
Revenue Service or Social Security Administration will never discover
any misclassificaton of a worker's status; however, because disgruntled
workers—especially those recently severed from employment and desiring
unemployment compensation—often are the whistle blowers to the federal
and state
governments, employers need to adopt a much more prudent posture in
classifying a worker's status.
According to the IRS, the main issue in determining a worker's status
is the degree of control an employer has or can have over the
worker. Under the common law, the treatment of a worker as an
independent contractor or an employee originates from the legal
definitions developed in the law of agency --whether one party, the
principal, is legally responsible for the acts or omissions of another
party, the agent --and depends on the principal’s right to direct and
control the agent. Following the common law standard, the
employment tax regulations provide that an employer-employee
relationship exists when the business for which the services
are performed has the right to direct and control the worker who
performs the services. This control refers not only to the result to be
accomplished by the work, but also the means and details by which that
result is accomplished. In other words, a worker is subject to the will
and control of the business not only as to what work shall be done but
also how it shall be done. It is not necessary that the business
actually direct or control the manner in which the services are
performed; it is sufficient if the business has the right to do so.
As
an aid to determining whether an individual is an employee under the
common
law rules, twenty factors or elements have been identified as
indicating
whether sufficient control is present to establish an employer-employee
relationship. The
twenty factors are enumerated below.
- Instructions:
A worker who
is required to comply with other
persons' instructions about when,
where, and how he or she is to work
is
ordinarily an employee. In other words, the principal has the
right to control how the job gets done and not merely the right to
require an end result. The more detailed the instructions are
that the worker is required to follow, the more control the business
exercises over the worker, and the more likely the business retains the
right to control the methods by which the worker performs the work.
Absence of detail in instructions reflects less control.
- Training:
Detailed
methods and procedures to be used in performing a task—as well as
periodic or on-going training provided by a business about procedures
to be followed and methods to be used—indicates that the business wants
the services performed in a
particular manner, and is strong evidence of an
employer-employee relationship.
- Integration: If the employee’s
services are an integral and important part of the operations of the
business, it suggests that the worker must be subject to the direction and control
of management, and, consequently, is an employee of the company.
- Services
Rendered Personally:
If the
services must be rendered personally, presumably the principal for whom
the services are performed is interested
in the methods used to accomplish the work as well as in the results.
An employee often does not have the
ability to assign his work to other employees; an independent
contractor may delegate the work to others.
- Hiring,
Supervising, and Paying Assistants:
If the
principal for whom the services
are performed hires, supervises, and pays
assistants, that factor
generally
shows control over the workers on the job and is indicative of an
employer-employee relationship. An independent contractor
ordinarily hires, supervises, and pays assistants under a contract that
requires him to provide materials and labor and to be
responsible only for the result.
- Continuing
Relationship:
If a business
engages a worker with the expectation that the relationship will continue indefinitely, rather than
for a specific project or period, this is generally considered evidence
of its intent to create an employment relationship. A "continuing
relationship" between employer and employee may exist even where
work
is performed at frequently recurring
although
irregular intervals.
- Set
Hours of Work: The
establishment of set hours of work
by the principal for whom the services are performed is a factor
indicating
control and an employment arrangement. An independent contractor
ordinarily establishes his own hours and schedule.
- Full
Time Required: If the worker
must devote substantially full
time to the business of the person or persons for whom the
services are
performed, such person or persons have control over the amount of time
the
worker spends working and impliedly restrict the worker from doing
other
gainful work. An employee normally works full time for an
employer. An independent contractor, on the other hand, is free
to
work
when and for whom he or she chooses.
- Doing
Work on Employer's Premises:
If the work
is performed on the premises
of the
person or persons for whom the services are performed, that factor
suggests
control over the worker and an employer-employee relationship,
especially if the work could be done
elsewhere. An independent contractor may perform the work
wherever he or she desires as long as the contract requirements are met.
- Order
or Sequence Set:
If a worker
must perform services in the order
or sequence set by the employer,
that requirement suggests control over the worker and an
employer-employee relationship. An independent contractor may
perform the work in whatever order or sequence he deems appropriate or
convenient as
long as the end results are achieved and all contract requirements are
met.
- Oral
or Written Reports: A
requirement
that the worker submit regular or
written reportsto
the person or persons for whom the services are
performed indicates
a degree of control over the process rather than the end result of a
contractual performance. Similarly, an evaluation system
measuring compliance with performance standards concerning the details
of how the work is to be performed, the system and its enforcement are
evidence of control over the worker’s behavior and indicative of an
employer-employee relationship.
- Payment
by Hour, Week, Month: A worker who
is compensated on an hourly, daily,
weekly, or similar basis
is guaranteed a return for labor. This is generally evidence of an
employer-employee relationship, even when the wage or salary is
accompanied by a commission.
Payment made by the job or on a straight commission
generally
indicates that the worker is an independent contractor.
- Payment of
Business and/or Traveling Expenses: If
the person or persons for whom the
services are performed ordinarily pay
the worker's business and/or
traveling expenses, the worker is ordinarily an employee.
If
expenses are unreimbursed, then the opportunity for profit or loss
exists, and suggests an independent
contractor relationship.
- Furnishing
of Tools and Materials: The
fact that the person or persons for whom the services are performed furnish significant tools, materials, and
other equipment tends to show
the existence of an employer-employee relationship.
- Significant
Investment: If the
worker
invests in facilities that are used by the worker in performing
services and are not typically maintained by employees,
that factor tends to indicate that the worker is an independent
contractor. Although not every
independent
contractor need make a significant investment, almost every independent
contractor will incur an array of
business expenses, including rent, utilities, equipment,
advertising, insurance, supplies, materials, repairs and maintenance,
etc. On the other hand,
lack of investment in facilities
indicates dependence on the person or persons for whom the services
are performed for such facilities and, accordingly, the existence of an
employer-employee relationship.
- Realization
of Profit or Loss: If
the worker can make a profit or
suffer a loss, the worker may be an independent contractor.
Employees are typically paid for their time and labor
and have no liability for business expensesee. The ability to
realize a profit or incur a loss is probably the strongest evidence
that a worker controls the business aspects of services rendered and is
therefore an independent contractor rather than an employee.
- Working for
More
Than One Firm at a Time: If a worker performs services for a
multiple of unrelated
firms at the same time, that
factor generally
indicates that the worker is an independent contractor.
- Making
Service Available to General Public: The fact that a worker makes his
services available to the general public on a regular and
consistent
basis indicates an independent contractor relationship. An independent contractor is generally
free to seek out business opportunities.
Indeed, the independent contractor’s economic prosperity depends on
doing so successfully. As a result, independent contractors often
advertise, maintain a visible business location, and are available to
work for the relevant market.
- Right to
Discharge: The right to
discharge a worker is a factor indicating that the worker is an
employee and the person possessing the right is an employer. An
employer exercises control through the threat of dismissal, which
causes the worker to obey the employer's instructions. An independent
contractor, on the other hand, cannot be fired so long as the
independent contractor produces a result that meets the contract
specifications.
- Right to
Terminate: If the
worker has
the right to quit a job at will
without incurring
liability, that worker is generally an employee.
Companies that hire unincorporated
individuals or entities as
independent contractors in particular are targets for IRS and Social
Security Administration audits and examinations, since they are
required to be issued 1099s, which are closely reviewed for worker
status. Violations of this employment law not only result
in penalties and fines to the employer but also to the employee, if he
has taken deductions on a tax return filed as a self-employed
individual
operating a business. Consequently, both employer and
employee must carefully scrutinize and evaluate the employment
situation to correctly determine the status of the working
relationship. Form SS-8, "Determination of Worker Status for
Purposes of Federal Employment Taxes and Income Tax Withholding", may
be filed by either the hiring company or the worker to request a
determination of the status of a worker for purposes of federal
employment taxes and income tax withholding. Of course, it is
always advisable to consult one's attorney and/or certified public
accountant for any assistance on a legal or tax issue.
Have a tax or an accounting question? Please feel free to submit
it to William Brighenti,
Certified Public
Accountant, Hartford CPA Accountants. For information
and assistance on
any tax and accounting issue, please visit our website: Accountants CPA
Hartford.
If and only
to the extent that this publication contains contributions from tax
professionals who are subject to the
rules of professional conduct set forth in Circular 230, as promulgated
by the United
States Department of the Treasury, the publisher, on behalf of those
contributors, hereby states that any U.S. federal tax advice that is
contained in such contributions was not intended or written to be used
by any
taxpayer
for the purpose of avoiding penalties that may be imposed on the
taxpayer by
the Internal Revenue Service, and it cannot be used by any taxpayer for
such
purpose. The above tax advice was
written to support the promotion or marketing of the accounting
practice of the publisher and any transaction described herein. The taxpayer recipients of this offering
memorandum
should seek
tax advice based on their particular circumstances from an independent
tax
advisor
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