An independent contractor (IC) is someone who is in an independent trade or profession offering services to the general public. An IC is considered to be able to control their own work, not the employer. By contrast, an employee’s work is controlled and directed by the employer.
Why Is the Distinction Important?
Many businesses classify workers as independent contractors because it’s cheaper than hiring employees. These businesses avoid:
Withholding Social Security and Medicare taxes, and paying a portion of those taxesPaying premiums for unemployment insurance and workers’ compensationAdhering to minimum wage, overtime, and other wage lawsBeing subject to employment laws like OSHA, ADA, and equal pay
But misclassifying workers as independent contractors instead of employees can result in high costs, including paying workers’ amounts owed for FICA taxes (Social Security and Medicare), and heavy fines and penalties.
IRS vs. Department of Labor Classification
The IRS separates and classifies workers as independent contractors or employees for employment tax purposes. As noted above, independent contractors are not subject to these taxes and businesses don’t have to contribute to these taxes. The Department of Labor (DOL) uses a different classification system to determine worker status for purposes of wage and hour laws, including minimum wages, overtime, and child labor laws. Independent contractors are not subject to these laws.
How the IRS Determines Worker Status
The IRS uses common law principles to determine if a worker is an independent contractor or an employee. This IRS review relates to federal employment taxes—federal income tax, FICA taxes for Social Security and Medicare, and federal unemployment taxes. In the past, a “20 Factor Test” was used to evaluate workers to determine whether they were independent contractors or employees. These factors have been compressed into three general categories for IRS review of the specific situation:
Behavioral controlFinancial controlRelationship of the parties
As you look at the factors below, you should be aware that the IRS does not look specifically at any one factor, but one factor can be enough to cause the IRS to determine that a worker is an employee. There is no “magic number” of factors that determine status.
IRS Factors for Determining Worker Status
The IRS no longer uses this specific 20-question test to determine worker status, but it might help you to understand the details of what is being evaluated.
U. S. Department of Labor Worker Status Test
The DOL determines worker status by looking at whether an “employment relationship” exists between a worker and an employer. If this relationship exists, then the worker is considered to be an employee under the provisions of the Fair Labor Standards Act (FLSA). An employee in this context is not someone who has a business of their own but is dependent on the business they serve. The text of the employee-employer relationship under the FLSA is what the DOL calls “economic reality.” Some of the factors that the Supreme Court has found to be significant, and which the DOL looks at, are:
Whether the services of the worker are part of the basic business of the employerThe permanency of the relationshipHow much the worker invests in facilities and equipmentHow much control the employer has over the workerThe worker’s opportunity for profit and lossThe amount of initiative, judgment, or foresight the person needs to compete in the open marketThe degree of independent business organization and operation.
Some factors aren’t important in determining the existence of an employment agreement, including
Whether there is a formal employment contractWhere the work is performedWhether the worker is licensedThe time or method of payment
State Tests for Independent Contractor Status
Each state has its own way to evaluate the status of workers for state wages, hours, and working condition requirements. Several states are now using what’s called a three-factor ABC test. This test, in brief, requires that all three of these factors must be met for the worker to be considered an independent contractor:
Getting a Review by the IRS
Are you wondering if your workers are classified correctly? You can ask the IRS to review using Form SS-8 to get a determination letter telling you whether your workers are contractors or employees. You may also apply to the IRS if you have been classifying workers as contractors in error. This application for “530 relief” allows you to get relief from liability or payment if you have been classifying workers as independent contractors in error. It looks at factors that might be in your favor as good faith efforts to comply with the law.
