Deciding the Status of an Independent Contractor

The determination of whether an individual is an independent contractor or an employee is crucial for both tax purposes and legal compliance. This article delves into the criteria used by major entities, such as the IRS, to decide an individual's status.

Who Determines the Status?

The answer lies with the 'client' or the company for whom the individual provides services. If the company has the authority to dictate what and when to do the work and how it is done, the individual is considered an employee. Conversely, if the individual is free to manage how the work is performed, and is paid a predetermined sum, they are generally considered an independent contractor.

Nutshell on Employee vs. Independent Contractor

Employee:

The company has the right to control the work and the manner in which it is completed. The company pays wages and provides tools and materials. The individual may use company equipment and benefits.

Independent Contractor:

The individual retains control over the means and methods for completing the work. The individual pays their own expenses and provides their own tools and materials. The individual typically enjoys greater freedom in choosing clients and project timelines.

The Role of the IRS

The IRS plays a significant role in ensuring compliance with the criteria for independent contractors. An IRS audit can have severe consequences if they determine that a company has misclassified employees as independent contractors. In such cases, the IRS may reclassify them as employees and impose back taxes, penalties, and immediate payment requirements from the employer.

Contrarians, however, may face few if any penalties if they have followed good-faith practices as independent contractors. Despite this, the IRS does provide a list of 20-odd distinguishing characteristics, though it does not clearly indicate which criteria are the most critical. The determination is often made through an assessment of the 'duck test': if it walks and quacks like a duck, it is likely a duck.

IRS Guidelines for Determining Status

The IRS provides comprehensive guidelines for determining the correct classification. One of the easiest ways to test the classification is by using the 'Common Law Rules.' These rules are based on three categories of evidence:

Behavioral Controls

Does the business control or have the right to control the worker's job duties and methods of performance?

Financial Controls

Is the business involved in the financial aspects of the worker's job, such as how they are paid, reimbursement of expenses, and provision of tools and supplies?

Type of Relationship

Are there written contracts, employee benefits, and a continuous relationship between the worker and the business, or is the work part of the regular business operations?

By evaluating these three categories, businesses can more accurately determine the status of their workers.

Conclusion

Understanding the criteria for classifying independent contractors is essential for ensuring compliance with tax laws and avoiding potential legal and financial issues. The guidelines provided by the IRS offer a structured approach for determining this status, which can help businesses operate more effectively and avoid costly misclassifications.