Employees & Independent Contractors: Staying Compliant with the IRS

The effects of the Coronavirus will be with us for a long time. One major effect for business is the move to home workers and the gigantic increase in the “gig economy.” Now more than ever, businesses are either moving employees to work from home, converting them to independent contractors, or hiring sub-contractors.

It is critical to your business that you understand how the IRS decides who is an employee or who is a sub-contractor for tax purposes. Here are the three basic test categoriesⁱ:

Control of Their Behavior

The extent of control over their work, behavior, and schedule plays a major part in this category determination:

What type of instructions do you give them? – Do you tell them where to work, what tools to use, or how and where to buy supplies or services? If you issue instructions in these areas, you could have them classified as employees.
How detailed are your instructions to them? – If you tend toward micro-managing, be careful. Too detailed instructions in how they do their work can get them classified as employees. It is best to clearly set out what you want for their product or service but stay away from detailing how they are to produce it.
How you evaluate their work. – While you can usually be OK with evaluating the quality of their product or service, stay away from evaluating how they perform the service or make the product.
Training is a red flag. – If you must train them to do what you want, they are going to be classified an employee in most cases. This includes ongoing training.

Financial Control

How much control over the financial or business practices does the business have over them? Think about:

Does the hiring business make a significant investment in the equipment used? If so, they are likely an employee, not an independent contractor.
Are their expenses reimbursed by the employing business? Independent contractors should show significant unreimbursed expenses.
If they have the opportunity and risk of profit or loss, they will likely be classed as an independent contractor.
Are they free to seek other business? If so, they are more likely to be considered a contractor for tax purposes.
How are they paid? If hourly, weekly, or monthly, it is more like wages and they are likely to be considered an employee. While independent contractors are best paid by the job or a flat fee, they could be paid hourly, but it should be documented how the hours are accounted for.

Relationship

Perceptions of how the hiring and the hired parties perceive their interaction is involved.

Written contracts are best, but they cannot just state the status. They should define a relationship that fits the other items above.
The provision of benefits such as insurance, pension plans, vacations or sick pay will generally get them classified as employees.
It is best to have a relationship defined by project or specific period, rather than an open-ended relationship that could indicate an employer-employee relationship.
The services or products delivered should be the key products or services offered to consider the relationship one of hirer and contractor.

Those are the factors considered by the IRS in classification of workers. Classifying someone as an independent contractor and later getting that reversed by the IRS can make the employer liable for employment taxes.

i Understanding Employee vs. Contractor Designation, IRS website.