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Classification of Employees under the IRS Guidelines

In our last post, we discussed analysis of the employer/independent contractor relationship through the lens of the Fair Labor Standards Act (“FLSA”). Employers who hire individuals as independent contractors – because it seems less often the case that an independent contractor is errantly classified as an employee – should keep in mind that the Internal Revenue Service (“IRS”) has its own set of standards for classifying employees for tax purposes. Thus, any analysis of employee classification under the FLSA should be, likewise, scrutinized through the lens of the IRS guidelines, of which there are many.

As a general rule, an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done: think of relationships with vendors and others who are retained for services but perform work without input from the payer. Whether a worker is an independent contractor or employee depends upon the circumstances of the parties’ relationship, with particular focus upon behavioral, financial, and other relationship-based factors (i.e. Are there written contracts or benefits? Does the relationship have a set term/duration?)

Businesses must evaluate the above factors when analyzing whether a worker is an employee or independent contractor. Many employers find especially challenging the common situation where some factors indicate that an individual is an employee, while other factors indicate that the individual is an independent contractor. Further complicating the issue, IRS guidelines make clear that there is not one factor in particular that unequivocally dictates the outcome of such analysis. Factors that are of great interest in one relationship may have no relevance to other employer/employee or payer/independent contractor relationships.

Fortunately, the IRS’s website provides additional guidance concerning the three largest categories of classification factors. To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

  • Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:
    • Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving instructions in these examples may indicate a worker is an employee.
    • More detailed instructions may indicate that the worker is an employee. Less detailed instructions demonstrate less control, making it more likely that the individual is an independent contractor.
    • Evaluation systems to measure the details of how the work is done suggests that a worker is an employee. However, evaluation systems measuring just the end result point to either an independent contractor or an employee.
    • Training a worker on how to perform a job — or periodic or on-going training about procedures and methods — is viable evidence that the worker is an employee. Independent contractors ordinarily implement their own methods of performing work. (More detail is available here).
  • Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:
    • The employer’s (or putative employer) investment in the equipment the worker uses in working for someone else. This can lead to an inference that a worker is an employee.
    • Independent contractors more often incur unreimbursed expenses than employees.
    • If there exists an opportunity for profit or loss, it can be indicative of an independent contractor relationship.
    • Independent contractors are generally free to seek out business opportunities, whereas employees may be restrained in some way from working simultaneously to provide the same services for other clients/employers.
    • An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee. (More detail available here)
  • Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
    • Written contracts can cut both ways in an employee/independent contractor analysis under IRS guidelines. However, the most critical point for any employer to understand is that a contract stating a worker is an employee or an independent contractor is not dispositive on the issue of worker classification. If a relationship appears to be employer/employee driven (more control and direction over areas beyond the results of the work) despite being categorized on paper as an independent contractor relationship, the facts will rule the day.
    • Businesses generally do not grant benefits such as vacation, health insurance, sick pay, pensions, etc., to independent contractors. Therefore, the presence of such benefits militates strongly for a conclusion that an employer/employee relationship exists.
    • The longevity of the relationship is also a crucial factor. A relationship that is somehow limited in duration may contribute to a conclusion that a worker is an independent contractor. However, if the relationship’s temporal scope is not defined, it is more likely suggestive of an employer/employee relationship. Other facts that suggest the intent of the parties in the initial phases of the relationship may influence analysis of this factor.
    • If the worker performs services that are vital to the regular function of the business or a critical component of its work, this factor may lead to a conclusion that a worker is an employee of the business. (More detail available here).

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

In addition, the IRS also applies a 20-factor-test that can be utilized to aid in the differentiation of employees from independent contractors. The factors include:

  1. the employer’s right to require the worker’s compliance with instructions;
  2. the employer’s training requirements;
  3. the integration of the worker’s services into the employer’s business;
  4. the worker’s personal rendering of services;
  5. the employer’s hiring, supervision, and payment of assistants;
  6. a continuing relationship between the employer and the worker;
  7. the employer’s setting of hours;
  8. the employer’s requirement of full-time service;
  9. performance of work on the employer’s premises;
  10. the worker’s performance of services in a sequence set by the employer;
  11. the employer’s requirement that the worker submit oral or written reports;
  12. payments on an hourly, weekly, or monthly basis;
  13. the employer’s payment of business or travel expenses;
  14. the employer’s furnishing of materials or tools;
  15. lack of significant investment in the facilities by the worker;
  16. lack of realization of loss or profit by the worker;
  17. lack of work for multiple firms by the worker;
  18. lack of availability of the worker’s services to the general public;
  19. the employer’s right to discharge the worker; and
  20. the worker’s right to terminate her or his services.

Consequences of Treating an Employee as an Independent Contractor

Misclassification of employees can have serious consequences. If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker, as applicable relief provisions, generally, do not apply to “unreasonable” misclassification.

With the assistance of legal counsel and their tax or accounting professionals, employers should, periodically, examine employees’ classifications and duties to determine whether employees and independent contractors are properly classified. If you have questions about the content of this article or wish to discuss any employment law issue, please contact Laura Musick or any of our employment lawyers.