Ask the Expert, Compensation

I Have a Question Regarding Compensation for Contractors vs. Employees

There is really no absolute definition of an independent contractor. The important distinction, from the point of view of an employer, is that an independent contractor is an individual who is performing services for the employer but who is not an employee.

Courts and government agencies generally examine the nature of the relationship between workers and employers to determine a particular individual’s status. Independent contractor status is generally characterized by an “arm’s length” relationship between the worker and employer. You will need to make this determination based on the details of the individuals’ working environment and relationships.

Reasonable Basis Test

The “reasonable basis” test provides a “safe harbor” to employers based on existing government or court classifications of workers in a particular business or industry and was mandated by the Revenue Act of 1978 (P.L. 95-600, Sec. 530), which provides that a worker may be appropriately classified as an independent contractor exempt from federal employment taxes if one or more of the following conditions are met:

  • Judicial precedent treating workers in similar circumstances as nonemployees
  • A Revenue Ruling issued by the IRS indicating that similar workers are exempt
  • An IRS Technical Advice Memorandum stating that the worker in question is not an employee
  • A long-standing and recognized practice in the industry of treating similar workers as nonemployees
  • A prior IRS audit finding that individuals in substantially similar positions were not employees

Common-Law Test

The common-law test may be used as an alternative to the “reasonable basis” test to classify workers. To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.

(1) Behavioral control. Facts that show whether the business has a right to direct and control how the worker performs his job functions include the type and degree of:

  • Instructions that the business gives to the worker. An employee is generally subject to the business’s instructions about when and where to do the work, what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what work must be performed by a specified individual, and what order or sequence to follow. The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
  • Training that the business gives to the worker. An employee may be trained to perform services in a particular manner. Independent contractors normally use their own methods.

(2) Financial control. Facts that show whether the business has a right to control the business aspects of the worker’s job include:

  • The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform with their business.
  • The extent of the worker’s investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
  • The extent to which the worker makes his or her services available to the relevant market. An independent contractor is generally free to seek out business opportunities. They often advertise, maintain a visible business location, and are available to work in the relevant market.
  • How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
  • The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.

(3) Type of Relationship. Facts that show the parties’ type of relationship include:

  • Written contracts describing the relationship the parties intended to create.
  • Whether or not the business provides the worker with employee-type benefits such as insurance, a pension plan, vacation pay, or sick pay.
  • The permanency of the relationship. If employers engage the worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the employer’s 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 workers provides services that are a key aspect of the employer’s regular business activity, it is more likely that the employer will have the right to direct and control his or her activities.
  • Note: Be careful of the lure of past practice. Even though similar positions or the same position may have been classified as an employee or independent contractor in the past, working arrangements typically change over time. Therefore, be certain to evaluate the current status of the position in light of these factors.

Please let us know in the comments if you have further questions.

  • Barb

    It’s important to note that the tests outlined above apply in the federal tax context. The DOL recently released guidance that describes a different test (and explicitly states that control is just a factor, and not a determinative one), and state agencies may have different tests, too.

  • This is good information; it is only half the equation. As Barb points out, the IRS uses the Common Law Control Test explained in the post. The Wage and Hour Division (WHD) of the DOL use a similar, but significantly different Economic Realities Test.

    Section 530 Safe Harbor is a statutory provision that allows employers who fail the IRS Control Test to continue to use independent contractors(IC), even though misclassified, and is not a separate test. Section 530 is law, not IRS code.

    The states use similar tests but it’s state by state.

    The DOL and IRS, along with more than 20 of the states have written agreements to share information about employee misclassification. Any misclassification enforcement action by one agency will probably trigger investigations by others.

    Finally, the DOL WHD has a Misclassification Initiative; they are actively looking for and aggressively pursuing violators.

    Companies need to be knowledgeable about both IRS and WFD regulations when employing ICs. An IC arrangement must be properly and meticulously structured, documented, implemented, and monitored to pass the tests. The financial cost of wage and hour violations for misclassification could far outweigh the services of a labor law attorney. Your corporate attorney, generally, will not be able to draft agreements that will pass the tests.