By: Brian J. Meli
It’s a dilemma that growing companies routinely face: whether to expand by hiring more employees, or assigning additional work to freelance contractors. It’s an especially common issue among advertising agencies and content providers, who routinely employ freelance creative personnel, and whose demand for creative talent often fluctuates dramatically from client to client and project to project. While the decision to hire outright or go the freelance route ultimately boils down to the particular business needs at hand, there are serious legal consequences that employers of all stripes should be aware of when considering their options.
While it may be tempting to staff a company comprised of freelance personnel to avoid paying employment taxes, workers’ compensation premiums and employee benefits, the misclassification of personnel as contractors when they actually function as employees can constitute payroll fraud and tax evasion. It’s a practice that both the Internal Revenue Service and the Department of Labor are taking major steps to crack down on. The DOL’s operating budget this year, as it has for the past few years, includes special funding for the detection and deterrence of companies misclassifying employees. Meanwhile, the agency’s Misclassification Initiative—aimed at restoring workers’ rights—is uniting various federal and state agencies, including the IRS, in this common cause.
Employers caught engaging in employee misclassification face a potentially devastating combination of fines and back tax penalties, and as more government resources are brought to bear to address the issue, the chances of an investigation and/or an audit only increase. This makes classifying new workers, and reevaluating the classifications of current workers, more important than ever.
Thankfully the IRS has made doing so relatively easy by simplifying the list of factors it uses in determining proper worker status. These 11 factors can be broken down into three distinct categories: financial control of the employer, behavioral control of the employer, and the type of relationship between the parties. Generally, the more control a company exercises over a worker, the more likely the IRS will find the existence of an employer-employee relationship, and therefore the more important it is to ensure the worker is being classified as such.
IRS worker classification factors:
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
1.) Instructions the business gives the worker. An employee is generally subject to the business’ instructions about when, where, and how to work. All of the following are examples of types of instructions about how to work:
- 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
- What order or sequence to follow
2.) Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Facts that show whether the business has a right to control the business aspects of the worker’s job include:
3.) 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 they perform for their business.
4.) The extent of the worker’s investment. An employee usually has no investment in the work other than his or her own time. 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.
5.) The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
6.) 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 by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
7.) The extent to which the worker can realize a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An independent contractor can make a profit or loss.
Type of relationship
Facts that show the parties’ type of relationship include:
8.) Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, the written contract can make a difference.
9.) Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. A true independent contractor will finance his or her own benefits out of the overall profits of the enterprise.
10.) The permanency of the relationship. If the company engages a 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 intent was to create an employer-employee relationship.
11.) The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company’s regular business activity, it is more likely that the company will have the right to direct and control his or her activities.
What becomes apparent after browsing the IRS factors is that there is no clear, bright line test for determining worker classification. Rather, these factors serve as guidelines, with each given more or less weight depending on the individual circumstances of each particular case. Therefore, if you’re unsure about how to classify a worker, you should consult a qualified employment law professional for guidance.
The content of this blog is intended for informational purposes only. The information provided in this blog is not intended to and does not constitute legal advice, and your use of this blog does not create an attorney-client relationship between you and Brian J. Meli. Under the rules of certain jurisdictions, the material included in this blog may constitute attorney advertising. Prior results do not guarantee a similar outcome. Every case is different and the results obtained in your case may be different.