Independent contractors checklist | How does the IRS classify independent contractors?

When you run a business, you're the one in charge. You make decisions about services, rates, location, and staff. However, determining whether a worker is an independent contractor or an employee isn't up to you. The IRS makes this call, distinguishing between W-2 employees and 1099 contractors.

The IRS has its rules, but each state might have different ones. To run a successful business with independent contractors, you must understand how the IRS sees them. This article breaks down the latest IRS test, explains how states might have their own rules, and looks at the specific impact of these laws on businesses working with independent contractors.

Who is an independent contractor? 

Independent contractors are professionals engaged by employers for specific services. They have more control over how they deliver their services. In the context of IRS guidelines, key factors determining an independent contractor’s status include:

1. Autonomy: Independent Contractors dictate their work methods and schedules.
2. No training: Independent Contractors typically use their own methods and tools without employer-provided training.
3. Business integration: Independent Contractors’ services are often supplementary and not integral to the employer's core business.
4. Risk and profit/loss: Independent Contractors bear the risk and have the potential for profit or loss based on their work outcomes.

Understanding these factors is crucial for accurate classification. As we explore the IRS checklist for independent contractors we'll delve into the various factors that help classify contractors and employees. 

Read more: Employee and Independent Contractor Misclassification

What happens if you misclassify an employee as an independent contractor? 

Employee misclassification is seen as a form of wage theft. Employee benefits are a crucial part of their overall compensation, and it is against the law to withhold entitled benefits, even if done unintentionally by the employer. 

In addition to harming employees, misclassification also results in the government losing tax revenue. Reporting such violations typically grabs the attention of the Department of Labor. The consequences include:

1. Loss of protection: Pursuing an IRS determination comes with trade-offs, as certain protections against liability for misclassification are forfeited. Employers may face penalties, liabilities, and legal challenges.
2. Financial implications: Misclassification may lead to retroactive employment taxes and withholding, resulting in a potentially substantial financial burden.

What can you do to avoid this? 

• IRS classification: Form SS-8 for an IRS determination. 
• Documentation: Maintain detailed records of contracts, work arrangements, and the independence of contractors in line with IRS criteria.
• Legal consultation: Seek legal advice to ensure compliance with evolving labor laws and IRS regulations.
• Regular audits: Conduct periodic internal audits to reassess worker classifications, ensuring ongoing alignment with IRS guidelines.

How does the IRS differentiate independent contractors from full-time employees?

The IRS employs several tests to determine the classification of workers as independent contractors or employees. The primary tests are the IRS 20-Factor Test, Common Law Test and the Economic Reality Test. Let's explore each of them:

The IRS 20-factor Test 

The IRS 20-Factor Test is a comprehensive set of factors used to determine whether a worker should be classified as an employee or an independent contractor. These factors are considered in assessing the employer's degree of control over the worker. Each factor is not necessarily decisive on its own, but collectively, it provides a holistic view of the working relationship. 

However, the IRS 20-factor test is no longer in active use. In 2019, the IRS determined that the 20-factor test was overly complex, and challenging to apply consistently. It introduced a new approach to classifying workers in their Employer’s Supplemental Tax Guide (Read the latest guidelines here). 

The IRS condensed the 20-factor test into the three-pronged or Common Law Test. While the factors remain similar, they have been organized into behavioral, financial, and type of relationship categories. Let’s explore.

Common Law Test 

The Common Law Test, also known as the Control Test, focuses on the degree of control exerted by the employer over the worker. It considers three main categories:

Behavioral control:

        Independence in work:

• Independent contractor: Has the freedom to determine how the work is performed.
• Employee: Typically follows employer-set procedures and guidelines.

        Training:

• Independent contractor: Pursues training independently.
• Employee: Often receives training from the employer.

Financial control:

        Investment in facilities and tools:

• Independent contractor: Invests in their own tools and equipment.
• Employee: Employer provides necessary tools and equipment.

        Expenses:

• Independent contractor: Bears their own business expenses.
• Employee: Employer typically covers work-related expenses.

        Method of payment:

• Independent contractor: Paid by the project or task.
• Employee: Receives regular salary or hourly wage.

Type of relationship:

        Contractual agreements:

• Independent contractor: Engages through a written/verbal contract specifying project scope and deliverables.
• Employee: Often has an ongoing employment contract.

        Benefits:

• Independent contractor: Typically does not receive employee benefits.
• Employee: Eligible for benefits such as health insurance, retirement plans, etc.

        Termination:

• Independent contractor: Contract duration is determined by the project.
• Employee: Generally has an ongoing relationship, subject to termination notice.

        Nature of work:

• Independent contractor: Often hired for specific projects or tasks.
• Employee: Integral to the core functions of the business.

While the IRS uses the Common Law test primarily for tax-related classifications, there are also region-based tests like the Economic Reality Test and the ABC test used by some jurisdictions. These tests are particularly associated with worker classification for purposes of wage and hour laws. Let’s explore them.

Read more: Benefits of Hiring Independent Contractors

The Economic Reality Test 

This testing procedure is used by various government agencies, including the U.S. Department of Labor (DOL), to determine the classification of workers as employees or independent contractors. While the IRS does not directly conduct it, it is an important consideration in employment classification.

Economic Reality Test Factors:

1. Degree of Control:

Similar to the Common Law Test, the level of control the employer has over the worker is a key factor. This includes control over work hours, tasks, and methods.

2. Opportunity for profit or loss:

Independent contractors typically can make a profit or incur a loss based on their business decisions. They invest in their tools, take on multiple projects, and have the potential for financial gain or loss.

3. Investment in facilities and equipment:

The extent to which the worker invests in their tools, equipment, or facilities. Independent contractors usually bear these costs themselves.

4. Special Skills:

Workers with specialized skills, training, or expertise that the employer does not provide may be more indicative of an independent contractor relationship.

5. Permanency of the working relationship:

An indefinite or permanent working relationship suggests an employer-employee relationship. Independent contractors are typically engaged for specific projects or a defined period.

6. Integration of the worker's services:

If the services provided by the worker are integral to the employer's business, it may lean toward an employment relationship.

The ABC 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 with respect to behavioral control, financial control, and the type of relationship between the employer and workers. However, the ABC test has a more stringent set of requirements. The test is named after its three criteria: A, B, and C. Each criterion must be met for a worker to be considered an independent contractor.

The ABC Test Criteria:

1. A (Control) assesses the degree of control the hiring entity has over the worker. Workers may meet this criterion if they have significant independence in performing their work. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
2. B (Business Outside the Usual Course) focuses on whether the work performed by the worker is outside the normal scope of the hiring entity's business. If the worker provides a service that is not a usual part of the company's operations, they may meet this criterion.
3. C (Independent Business) evaluates whether the worker is independently established in a trade, occupation, or business similar to the work they perform for the hiring entity. Workers may meet this criterion if they have their own businesses or are engaged in a similar trade.

Hire independent contractors in compliance with the IRS

Expanding your team globally with full-time employees and contractors? 

Gloroots offers seamless solutions for hiring independent contractors while ensuring compliance with IRS regulations. Without the need for extensive compliance research, Gloroots helps you effortlessly adhere to the local laws of every country. Elevate your team with skilled professionals, all without the headache of misclassification. Let Gloroots be your strategic partner in smart and compliant staffing.

Check out how Gloroots helped PriceLabs hire its Indian team, ensuring 100% compliance with the Indian taxation and hiring norms.

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