Treasurer's Office

Employee vs Independent Contractor Classificiation

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Employee vs. Independent Contractor Classification

Payroll/Vendor Tax Guideline 107

Updated July 28, 2006  


Scope - This guideline addresses the general criteria used in determining appropriate employee or independent contractor classification and the tax implications involved.

General - An employee/employer relationship generally exists under the common law when the worker is subject to the right of control by the business as to what work shall be done and how it shall be done. The IRS has developed a 20-factor test presented below to aid in determining whether a business has the right to control and direct a worker. Although the general importance of each factor varies, the IRS has identified three primary categories of evidence to assess in determining worker classification. These categories are behavioral control, financial control and the relationship of the parties. Each category is more fully described in the Independent Contractor or Employee IRS Training Manual, which can be obtained from the University Tax Manager.

Behavioral Control
Behavioral control derives from facts that illustrate a right to direct or control how the worker performs their tasks. Examples of behavioral facts from the IRS twenty factors are as follows:

  • Instructions (IRS factor 1) - 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. This control factor is present if the person or persons for whom the services are performed have the RIGHT to require compliance with instructions.
  • Training (IRS factor 2) - Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner.

Highly trained professionals such as physicians, accountants, lawyers, engineers, or computer specialists may require very little, if any, training and/or instruction on how to perform their services. Therefore, such professional workers who are engaged in the pursuit of an independent trade, business, or profession, in which they offer their services to the public are generally independent contractors and not employees (Treasury Regulation 31.3121(d)-1(c)(2)). See excerpt from IRS Revenue Ruling 66-274 presented below for criteria to assess when determining worker classification of a physician.


Financial Control
Financial control derives from facts that illustrate a right to direct or control how the business aspects of the worker's activities are conducted. Examples of financial factors from the IRS twenty factors are as follows:

  • Realization of profit or loss (IRS factor 16) - A worker who can realize a profit or suffer a loss as a result of the worker's services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is generally an employee. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.
  • Significant investment (IRS factor 15) - If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. 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. Special scrutiny is required with respect to certain types of facilities, such as home offices.

Relationship of the Parties
Facts that illustrate how the parties perceive their relationship with the other. Examples of relationship factors from the IRS twenty factors are as follows:

  • Continuing relationship (IRS factor 6) - A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.
  • Working for more than one firm at a time (IRS factor 17) - If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.


IRS Twenty Factor Test (As taken from IRS Revenue Ruling 87-41)
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 have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. The twenty factors are designed only as guides for determining whether an individual is an employee; special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee). The twenty factors are described below:

  1. 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. This control factor is present if the person or persons for whom the services are performed have the RIGHT to require compliance with instructions.
  2. TRAINING - Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner.
  3. INTEGRATION - Integration of the worker's services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends to an appreciable degree upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business.
  4. SERVICES RENDERED PERSONALLY - If the Services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results.
  5. HIRING, SUPERVISING, AND PAYING ASSISTANTS - If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status.
  6. CONTINUING RELATIONSHIP - A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.
  7. SET HOURS OF WORK - The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control
  8. 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 independent contractor on the other hand, is free to work when and for whom he or she chooses.
  9. 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, especially if the work could be done elsewhere. Work done off the premises of the person or persons receiving the services, such as at the office of the worker, indicates some freedom from control. However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer's premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required.
  10. ORDER OR SEQUENCE SET - If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker's own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if such person or persons retain the right to do so.
  11. ORAL OR WRITTEN REPORTS - A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control.
  12. PAYMENT BY HOUR, WEEK, MONTH - Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on straight commission generally indicates that the worker is an independent contractor.
  13. 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. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker's business activities.
  14. 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.
  15. SIGNIFICANT INVESTMENT - If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. 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. Special scrutiny is required with respect to certain types of facilities, such as home offices.
  16. REALIZATION OF PROFIT OR LOSS - A worker who can realize a profit or suffer a loss as a result of the worker's services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.
  17. WORKING FOR MORE THAN ONE FIRM AT A TIME - If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.
  18. MAKING SERVICE AVAILABLE TO GENERAL PUBLIC - The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.
  19. 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.
  20. RIGHT TO TERMINATE - If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship.

Additional Factors (As Taken from the Independent Contractor or Employee IRS Training Manual referenced above)
In its Independent Contractor or Employee Training Manual, the IRS identified certain other facts that were relevant in court decisions regarding worker classification. The other facts presented in the training manual primarily relate to how the worker and employer perceive their relationship. We have presented a few examples below of the other factors for informational purposes.

Intent of parties/written contract - A written agreement describing the worker's classification is evidence of the intent regarding the working relationship. However, the contract itself is not sufficient evidence regarding worker classification. Therefore, the substance of the written agreement should be assessed in combination with all other relevant facts and circumstances.

Forms W-2 - Filing a Form W-2 for a worker generally indicates employee status.
Incorporation - Workers who create a corporation and provide services to a business are generally considered independent contractors of the business.Employee benefits - If a worker receives employee benefits, such as paid vacation days, paid sick days, health insurance, life or disability insurance, or a pension, the worker generally would have employee status. Employee benefit facts lending towards employee status are generally strongest if the worker is provided with a tax-qualified retirement plan, IRC section 403(b) annuity, or cafeteria plan.

Discharge/termination - The circumstances under which a business or worker can terminate their relationship with the other party are generally considered useful evidence regarding worker classification. However, due to the complexity regarding the right to discharge or terminate, this type or evidence should be used with caution.

Excerpt from IRS Revenue Ruling 66-274 Regarding Physicians
Physicians who engage in the pursuit of an independent medical practice in which they offer their services to the public are generally independent contractors, but that if the requisite control and supervision exist over a physician with respect to services performed for another he is an employee. Whether the requisite control and supervision exist is determined by such criteria as:

  1. the degree to which such individual has become integrated into the operating organization of the person or firm for which the services are performed;
  2. the substantial nature, regularity, and continuity of his work for such person or firm;
  3. the authority vested in or reserved by such person or firm to require compliance with its general policies; and
  4. the degree to which the individual under consideration has been accorded the rights and privileges which such person or firm has created or established for its employees generally.

Regarding the first criterion mentioned above; integration does not mean simply that the services performed by the physician are services that are required in the operating organization of the person or firm for which he renders his services, as integration to this extent will usually be present. More important in this connection is the MANNER in which the services of the physician are integrated into the particular operation. Significant here are such factors as:

  1. the manner in which the physician is paid for his services, that is, whether on a percentage basis, salary, or percentage with a guaranteed minimum;
  2. whether he is permitted to employ associate physicians or to engage substitutes when he is absent from his work and, if so, whether he is responsible for the remuneration paid to any associates or substitutes engaged by him; and
  3. whether the physician is permitted to engage in the private practice of medicine or to perform professional services for others.

 

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