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The Proper Classification of Workers

Accounting & Budgeting

To determine whether a worker should be classified as an employee or an independent contractor, the IRS (and state tax agencies) will use 20 different common law criteria to examine the degree of control your company has over that worker. If you have the right to direct or control the specific tasks and the where and the how of the worker's activities, the IRS will likely consider that person an employee, regardless of the title you've given them.

The IRS prefers to classify workers as employees rather than independent contractors because it collects more tax revenue if the worker is an employee. If the person qualifies as an employee, the IRS rules require that the employer withhold income taxes and the employee's share of Social Security and Medicare contributions.

Penalties for Wrongful Classification

If the IRS determines that a worker should have been classified as an employee rather than an independent contractor, it can assess the following fees:

  • Payment of federal income tax that should have been withheld from the employee
  • Payment of Medicare contributions that should have been withheld
  • Interest on taxes that should have been withheld
  • A penalty for failure to properly file tax returns and pay taxes
  • A more substantial penalty if the IRS determines there was negligent, intentional, or fraudulent behavior
  • Criminal sanctions, including imprisonment and fines up to $100,000
  • Personal liability for corporate officers, up to 100 percent of the amount the employer should have withheld from the employee's compensation

Other governmental entities, such as the State Employment Department or the National Labor Relations Board, may also impose fines.

However, there is an important protection for employers who have misclassified employees erroneously — section 530. If an employer passes two tests, a consistency test (1099s were filed for all employees in question and all such employees were treated the same) and a reasonableness test (the employer had reason to believe that the employees should be treated as contractors based on, for example, a court decision or industry practice), then the employer may be found not liable for the taxes of these workers.

Rules to Determine Worker Classification

In late 1996, the IRS published the "Worker Classification Training Materials" to educate its tax examiners. The manual suggests examiners check three areas to show the degree of control a business has over a worker — behavioral control, financial control, and the type of relationship between the worker and the business.

Behavioral Control

  • Worker instructions. An employee is generally subject to the business's instructions about when, where, and how to work.
  • Worker training. An employee may be trained to perform work in a certain way. Independent contractors ordinarily use their own methods.

Financial Control

  • The extent to which the worker has unreimbursed business expenses. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important.
  • The extent of the worker's investment. An independent contractor often has a significant investment in a home office, including computer equipment.
  • The extent to which the worker is available to work for other businesses. Employees generally are not free to take on other work. Independent contractors may work on several projects at the same time.
  • How the business pays the worker. An employee is generally paid by the hour, week, or month. An independent contractor is usually paid by the project.
  • The extent to which the worker can realize a profit or incur a loss. Depending on how quickly a project is completed or how long a project takes, an independent contractor can make a profit or loss.

Type of Relationship

  • Written contracts describing the worker-business relationship. It is desirable to have a written independent contractor agreement or consultant agreement that states the worker is an independent contractor.
  • Whether the business provides the worker with employee-type benefits, such as insurance, vacation pay, or sick pay. Independent contractors typically don't receive any of these benefits.
  • The permanency of the relationship. Engaging a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, can be considered evidence that your intent was to create an employer-employee relationship.
  • The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control the worker's activities.

IRS Publication 15-A offers real examples of whether a worker should be classified as an employee or an independent contractor.

Certain Workers Are Automatically Classified as Employees

The IRS rules provide that certain workers are automatically classified as employees for tax purposes. Such employees include certain delivery drivers, certain insurance agents, workers working at their home using materials or goods that are supplied by the company, and certain business-to-business salespeople.