Running your business is an exciting venture—until tax season. Among the numerous tax-related issues to consider is whether your employees are correctly classified as employees or independent contractors. It’s critical to understand this distinction, because as an employer, you’re responsible for various tax withholdings and filings. To guide you, the Internal Revenue Service (IRS) has an independent contractor test to help classify workers as W-2 employees or 1099 contractors.
While the IRS has a clear demarcation between employees and independent contractors, it’s still difficult to comprehend every aspect of the classifications. What’s more, some states may operate on a different test beyond the one used by the IRS. And for business based in California, classification is made more challenging with the passage—and subsequent exemptions—of the AB5 law.
To run a successful and compliant business with independent contractors as part of your workforce, you must first understand how the IRS categorizes independent contractors. This article will explain the latest test used by the IRS to classify workers, how states’ independent contractor tests vary from the IRS, and how California’s laws for classifying workers affects businesses with contractors.
How does the IRS determine whether a worker is an employee or an independent contractor?
Today, the IRS uses a three-pronged test—also known as the common law test—to determine if workers are employees or independent contractors. Before adopting the common law test, the IRS utilized a 20-point criteria test. The common law test is derived by the contents of the 20-point test.
IRS common law test
The three factors of the common law test are behavioral control, financial control, and the relationship of the parties. Let’s take a closer look at each one:
Behavioral control
Behavioral control looks at the type and level of control an employer has over how workers accomplish their tasks. When looking at behavioral control, you need to check whether an employer influences where and when employees do their duties.
For example, if an employer requires workers to use specific tools or adhere to a strict schedule, that would be indicative of behavioral control.
On the other hand, independent contractors typically have more freedom in how they complete their work. For instance, an electrician may choose what type of wire to use on a job and can set their own hours.
The IRS lists four factors to consider within behavioral control:
Type of instructions
When a worker receives instructions on when and how to do work, plus the schedule and equipment, then they should be classified as an employee.
The greater the amount of instruction, the more likely the worker is an employee. Conversely, fewer details show lesser control by the employer, meaning the worker is more likely to be considered an independent contractor.
Evaluation system
If there’s an evaluation system assessing how work is performed, this points to classification as an employee. On the other hand, if only the result is judged, the worker may be an employee or an independent contractor.
Training
When there’s ongoing and periodic training about how a worker should perform a task, there’s a strong indication the worker is an employee. If the worker falls back on their own method and knowledge, they are more likely to be an independent contractor.
Financial control
Factors under financial control examine the extent to which an employer controls the economic aspects of a worker’s job. This includes how the worker is paid, whether they incur expenses, and if they have a chance for profit or loss. For example, if a worker is paid by the hour, this is an indication of financial control by the employer.
Here are the 5 factors the IRS uses to measure financial control:
Significant investment
There’s no specific amount of money a worker needs to meet to prove they’re contributing significant investment in their work. However, independent contractors do spend more money on tools and equipment than employees. They also have a higher chance of incurring losses related to their work.
Unreimbursed expenses
If workers incur unreimbursed expenses, this is an indication they’re an independent contractor. For example, if a worker pays for their own travel or office supplies, they can deduct these from their taxes as business expenses. On the other hand, employees typically have these expenses reimbursed by their employer.
Opportunity for profit or loss
Independent contractors typically have the opportunity to make a profit or incur a loss as part of their work. For instance, they may be able to negotiate higher pay for jobs that require more risk. On the other hand, employees usually receive a set wage regardless of how well the business is doing.
Services available to the market
Independent contractors are usually free to market their services to other businesses. They’re also able to work for multiple companies at the same time. On the other hand, employees typically can’t do this as they have a contract with one employer. Employees often have to be aware and abide by employment policies regarding side hustles, gig work, and second jobs.
Method of payment
Independent contractors are typically paid in one lump sum after they complete a project. They don’t receive regular paychecks like employees do. Instead, they submit invoices to their clients for payment. Employees, on the other hand, have taxes taken out of their paycheck and receive benefits such as vacation pay and health insurance.
Type of relationship
The final factor the IRS uses to determine worker classification is the type of relationship between a worker and an employer. Again, four factors help the IRS classify an employer-worker relationship.
Written contracts
The existence of a contract is not determinative by itself. However, the language used in the contract can provide insight into the type of relationship between a worker and an employer. For example, if a contract refers to a worker as an employee, this is usually an indication the IRS will classify them as such.
Employee benefits
If a worker receives benefits such as health insurance and vacation pay, this is an indication they’re an employee. On the other hand, independent contractors typically don’t receive these types of benefits. That said, benefits are not a sufficient method of classifying workers.
Permanency of the relationship
If a worker is hired for a specific project with a set end date, they’re more likely to be classified as an independent contractor. On the other hand, if there’s no end date or the employer has the option to renew the contract, this is an indication the worker is an employee. The IRS sees it as the intent of creating an employee-employer relationship if you hire a worker indefinitely.
Services provided
The final factor is whether the services provided by the worker are a key activity of the business. For example, if you hired someone to mow your lawn, they would not be considered an employee as landscaping is not a key activity of your business. However, if you hired someone to design a website for your business, they’re more likely to be considered an employee as website design is a key activity.
Does the IRS use the 20-factor test for worker classification?
The IRS used to use a 20-factor test for worker classification, but it’s no longer in use. This test looked at factors such as who controlled the work, whether the workers had set hours, and whether they received training from the employer. In 2019, the IRS found that this test was too complicated and difficult to apply consistently and revealed a new way of classifying workers in their Employer’s Supplemental Tax Guide (2020). Essentially, the IRS compressed the 20-factor test into what we now know as the three-pronged test or the common law test. The factors are quite similar, but they’ve been categorized into the behavioral control, financial control, and type of relationship factors we reviewed above.
A closer look at these 20-factor questions, and you’ll see them reflected in the three categories of behavioral, financial, and relationship control.
A review of the IRS 20 factor test
- Instructions (type and extent): Does the worker need to comply with employer instructions on how, where, and when to work?
- Training: Does the worker receive periodic or ongoing training on performing services rendered?
- Integration in business operation: Do the services rendered by the worker a core business activity? Does the business’s success heavily rely on the worker’s performance?
- Services Rendered Personally: Does the employer require the worker to perform the service personally?
- Authority to hire, supervise and pay assistants: Can the worker hire, pay and supervise assistants for the employer?
- Continuing Relationship: Do the worker and employer have a continuing(indefinite relationship)?
- Set Hours of Work: Is it mandatory for the worker to perform based on an employer-set schedule?
- Full-time Work Required: Does the worker need to devote full time to an employer?
- Place of Work: Is the worker required to perform their tasks on the employer’s premises?
- Sequence of Work: Does the worker perform based on a set schedule set by the employer?
- Oral or Written Reports: Does the employer expect the worker to submit regular verbal and written reports?
- Method of Payment: Does the worker receive regular payments at scheduled intervals? Also, how is the worker paid?
- Payment of Business and Travel Expenses: Will the worker receive reimbursements and payments for business and travel expenses?
- Furnishing tools and materials: Does the worker rely on the providence of employers for tools and materials?
- Investment: Has the worker invested heavily in equipment and tools to perform a service?
- Profit or Loss realization: Will the worker receive a fixed payment regardless of profit or loss?
- Working for more than one entity at a time: Does the worker only work for one employer or business entity at a time?
- Is service available to the public: Are the services offered by a worker unavailable to the public?
- Right to discharge: Can an employer fire the worker?
- Right to quit: Can the worker quit work without any liability?
ABC test vs. the common law test
The ABC test is used by some states, such as California, Massachusetts, and New Jersey, to classify workers. This test is similar to the common law test in that it looks at behavioral control, financial control, and the type of relationship between the employer and employee. The main difference is that the ABC test has a more stringent set of requirements for classification as an independent contractor.
Under the ABC test, a worker is always an employee unless an employer can prove all three of the following:
A. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under their contract for the performance of work and in fact.
B. The worker performs work that is outside the usual course of the hiring entity’s business.
C. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
The ABC test is not without its criticisms. The main argument against the test is that it’s inflexible and doesn’t take into account the nuances of different working relationships. The common law test is more flexible than the ABC test and takes a broad view of what it means to be an independent contractor. If an employer has control over one or more of the behavioral, financial, and relationship factors, only then is the worker classified as an employee.
If a worker is found to be an employee under the common law test, they will most likely be classified as an employee under the ABC test as well. In short, the key difference between the ABC test and the common law test is that the ABC test assumes the worker is an employee and the burden of proof is on the employer to show that the worker is an independent contractor. The common law test starts with the assumption that the worker is an independent contractor and it’s up to the IRS or other entity to prove that the worker is actually an employee.
Independent contractor tests across states
Unfortunately, there is no one-size-fits all answer when it comes to classifying workers as independent contractors. The IRS and many U.S. states use the common law test, but others use the ABC test or a hybrid of the two tests. And, as if that wasn’t confusing enough, some states have their own independent contractor test that’s different from both the common law and ABC tests.
As you can see, there is no federal independent contractor test. The IRS uses the common law test, but states are free to choose their own classification test. This can create confusion for businesses with workers in multiple states. If you have any questions about how your state classifies workers, you should contact your state’s labor department and consult with an attorney.
California’s AB5 law and worker classification
California’s AB5 law is well-known in the news for adding complexity to the worker classification debate. The law codifies the ABC test and makes it the sole method of classification for most workers in California. California defaulted to the ABC test after the Los Angeles Superior Court ruled in the Dynamex Operations West vs. Superior Court of Los Angeles case in 2018. Drivers of Dynamex, a document delivery company, alleged the company had misclassified them as independent contractors instead of employees.
The California Supreme Court concluded that the ABC test should be the de facto method of classifying workers for wage laws and regulations in the state. Unless companies proved that workers did not fall under the three factors in the ABC test, they are to be treated as employees where wage order laws are concerned. The case ruling was a landmark in California, leading to the enactment of AB5 law.
Since AB5 passed, exemptions have been made for some professions. In fact, the list of exemptions has become so long, some of called for the bill to be repealed or replaced. AB5 remains contested while other states study its impacts in order to make decisions about their own worker classification laws. Other states, such as Massachusetts, have also adopted the ABC test to determine the classification of employees and gig workers or independent contractors.
What are the penalties for worker misclassification?
An Economic Policy Institute report found that 10-15% of employers misclassify at least one worker as an independent contractor. Misclassified workers miss out on fair compensation, safety protection, the right to organize, and unemployment benefits. Sometimes, misclassification is a lack of due diligence on the employer’s side. Other times, it’s an intentional but wrong strategy that puts the risk on workers and creates an unfair market advantage.
That’s why misclassification attracts stiff penalties. In addition, once the misclassification is brought to light, you will owe the state back taxes, worker compensation premiums, unpaid overtime, and a slew of other payments. In 2014, FedEx misclassified their Oregon and California drivers as independent contractors. The misclassification cost FedEx $225 million even though they had a contract saying the drivers were independent contractors. You can see how workers misclassification can end up being very costly for companies.
How can you stay compliant with the IRS worker classification rules?
The best way to avoid penalties is to correctly classify your workers from the start. However, if you’re looking to determine the classification for current workers, it’s important to recognize the importance of the decision on your business as well as the workers themselves. If you’re unsure about how to proceed, it’s best to seek professional help. An employment lawyer can help you analyze your options and make the best decision for your business.
IRS’s Voluntary Classification Settlement Program
If you’re not sure how to classify a worker, you can use the IRS’s Voluntary Classification Settlement Program (VCSP). This program offers employers a way to reclassify their workers as employees with partial relief from federal employment taxes. You can apply for the VCSP if you meet the following criteria:
- You have consistently treated the workers in question as independent contractors.
- You haven’t currently classified them as employees and filed Forms W-w for them.
- You don’t currently have any open employment tax audits with the IRS.
- You agree to treat the workers as employees going forward.
You can apply for the VCSP by filing Form 8950 with the IRS. After you file, an eligibility determination will be made, and you’ll receive a closing agreement outlining the terms of your participation in the program.
The VCSP is a great way to come into compliance without having to pay all of the back taxes and penalties. If you think you may have misclassified workers in the past, the VCSP can help you get right with the IRS.
Go beyond your contracts
Additionally, understand that a contract does not hold much weight in classifying a worker as an employee or independent contractor. You’ll have to dive deeper into analyzing the employer-worker relationship against the IRS common law test.
IRS Form SS-8
If you’re still in doubt, you can file IRS Form SS-8 to request the IRS to determine whether your worker(s) is an independent contractor or employee. As an FYI, it can take up to six months for the IRS to provide a determination. They can also audit your business if they think you have misclassified workers.
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