One question that often comes up during tax planning is how you should pay a worker. This is a difficult question to answer, because it sometimes is not black or white. You need to look at the IRS and Department of Labor's (DOL) regulatory guidance as well as case law to determine if a worker is an employee or independent contractor.
The common law test developed by the IRS uses 20 factors to determine if a worker is an employee or independent contractor. The IRS subsequently updated the employee/independent contractor test into three controlling factors: behavioral control, financial control and relationship control.
The behavioral control test boils down to the employer having control over the worker and how he or she accomplishes the job. Factors include the type of instruction given, degree of instruction, evaluation system and training. To sum it up, a person is an employee if the employer controls where/when they work, provides detailed instructions on how the work should be done, provides detailed training and provides periodic feedback on how they are doing.
The financial control test looks at who bears the economic benefits and burdens of the workplace relationship. This test focuses on the employee side of the equation. Independent contractors typically make a significant investment in order to accomplish their job. They are more likely to have unreimbursed expenses and may incur a loss in the business relationship. An independent contractor also tends to have a separate place of business, advertise and has the ability to work for others. Another sign of being an independent contractor is irregular pay, that is compensation is not paid weekly, biweekly or monthly.
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The relationship test focuses on how both sides perceive their relationship. Factors include written contracts, employee benefits, duration of relationship and services provided. Does the worker have paid vacation and/or retirement benefits? Is the relationship long-standing?
You must look at the 20-factor test and three-factor test through the lens of the entirety of the relationship. Some of the tests may lean toward treating the worker as employee, whereas others lean toward independent contractor. This is why determining the correct classification can sometimes be difficult.
In addition to the IRS, the DOL uses an economic reality test that focuses on six factors. The DOL test is more likely to classify a worker as an employee than the IRS.
Why is worker classification important? The consequences of a wrong classification can be severe, including criminal prosecution. The IRS has a series of penalties they can impose, inducing 100% of the total tax not collected or paid. So, when there is doubt, it's better to take the side of employee and not independent contractor.
DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota.
Read Rod's "Ask the Taxman" column at about.dtnpf.com/tax.
You may email Rod at firstname.lastname@example.org.
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