Employee Or Independent Contractor:
Have You Classified Your Workers Correctly?

The decision to classify workers as employees or independent contractors is a decision which has crucial tax consequences. The Employment Development Department of the State of California (EDD) and the IRS have, in recent years, undertaken substantial audit activity to determine whether employers have improperly characterized "employees" as "independent contractors" for the purpose of avoiding the payment of Social Security, Medicare and unemployment taxes, and the withholding of income, Social Security and State Disability taxes on wages that are actually or constructively paid to an employee.

Even the unintentional misclassification of a worker as an independent contractor rather than an employee will cause the imposition of substantial financial liability on the part of the employer. In addition to being liable for the employment taxes which would have been payable if the employer had correctly classified the worker as an employee, the employer will also likely be required to pay the amount of income and other payroll taxes that should have been withheld from compensation received by the employee, in the event the employee has failed to do so. Intentional misclassification will also result in the imposition of substantial penalties.

If there is a duty to pay such taxes and the employing entity cannot do so, the government will nonetheless attempt to collect the taxes from any "responsible person" related to the employer. Officers of a corporation, for example, particularly those officers with any control over funds, are generally considered "responsible persons" and subject to such tax liability, regardless of their ownership interest in the corporation.

In order to assist in the determination as to whether a worker is an employee or an independent contractor, the IRS has developed a twenty-factor test. These factors are designed to help determine whether sufficient control is present to establish an employer- employee relationship. Since the IRS is concerned that form be not elevated over substance, careful attention is required in applying these twenty factors. The twenty factors, with comment when the factor is not self-explanatory, are as follows:

1. Instructions. A worker who must comply with another person's instructions about when, where and how the worker is to perform, is ordinarily considered an employee. This factor of control is generally given considerable weight.
2. Training. A worker required to learn by working with an experienced employee suggests that the services are to be performed in a particular method or manner and thus is further evidence of the control reflective of an employer-employee relationship.
3. Integration. When the success of a business depends to an appreciable degree upon the performance of certain services, the worker who performs these services must necessarily be subject to a certain amount of control by the owner of the business.
4. Services rendered personally. Services rendered personally by the worker would indicate an employer-employee relationship.
5. Hiring, supervising and paying assistants. If a worker hires, supervises or pays assistants under a contract under which the worker has agreed to provide materials and labor, and under which the worker is responsible for the attainment of a result, independent contractor status may be indicated.
6. Continuing relationship. This factor indicates an employer-employee relationship.
7. Set hours of work. If the hours of work are set by the supervisor, the relationship is more likely employer-employee.
8. Full time required. If full time work is required, an employer-employee relationship is indicated.
9. Doing work on employer premises.
10. Order of sequence set. If a worker must perform services in the order or sequence established by the owner of the business or supervisor for whom the services are to be performed, this factor demonstrates that the worker is not free to follow his or her own pattern of work, but must, instead, follow established routines and schedules.
11. Oral or written reports. A certain degree of control is demonstrated by the requirement that the worker submit regular reports to persons for whom services are to be performed.
12. Payment by hour, week, month.
13. Payment of business and/or traveling expenses.
14. Furnishing of tools and materials. If the owner of the business provides the tools and materials, rather than the worker providing his or her own tools, an employer-employee relationship is indicated.
15. Significant investment. If a worker invests in equipment that is used by the worker in performance of the services such as the maintenance of an office rented at fair market value from an unrelated party, such a factor would indicate that the worker is an independent contractor. If, on the other hand, there has been no investment in facilities, it would appear that the worker has dependence upon the person for whom services are to be performed and the existence of an employer-employee relationship is indicated.
16. Realization of profit or loss. If a worker has a bona fide liability for expenses such as salary payments to unrelated employees, the worker would appear to be an independent contractor.
17. Working for more than one firm at a time. If the worker devotes all of his or her attention to one firm, an employer-employee relationship is indicated.
18. Making service available to the general public.
19. Right to discharge. An independent contractor can generally not be fired so long as such an individual produces a result that meets contract specifications; however, if the person for whom services is to be performed has the right to exercise control through the threat of dismissal, the worker would appear to be an employee.
20. Right to terminate. If a worker has the right to end the relationship without incurring liability, such a factor would indicate an employer-employee relationship.

Remember, if you treat your workers as employees, the IRS and EDD will have nothing to complain about. If you engage in conduct that either or both of these agencies finds improper, you may find yourself with a business headache for which there is no inexpensive over-the-counter remedy!

[This column is intended to provide general information only  and
is  not intended to provide specific legal advice; if you have  a
specific  question  regarding the  law,  you  should  contact  an
attorney  of your choice.  Suggestions for topics to be discussed
in this column are welcome.]


Reprinted from New Era Magazine
Myles M. Mattenson © 1995-2002