Employee vs. Independent Contractor:
A Game of 20 Questions

by Christina Morfeld

In today's economic climate, downsizing is an unfortunate reality for many businesses. Despite staff reductions, a company must continue to produce if it is to survive long term. While contingent staffing may seem like a logical way to get the work done (and keep headcount - and associated employment costs such as taxes and benefits - down), think twice before engaging the services of a so-called "independent contractor."

Simply because (a) you refer to a worker as an IC, (b) he or she has agreed to the arrangement in a written contract, and (c) payments are issued by accounts payable rather than the payroll department does not mean that the individual is, in fact, an IC. The nature of the relationship between the individual and the company is the true determinant and misclassification can result in serious consequences for an organization. These consequences include backpaying taxes, providing benefits - including vacation pay, stock options, and 401(K) contributions - retroactively, and stiff financial penalties.

There are a number of events that may trigger an investigation into your worker classification practices. For example, a contingent worker may apply for unemployment benefits at the conclusion of his or her contract, make a complaint of discrimination or harassment, or file a Worker Compensation claim. Additionally, the IRS may target your organization for an audit, either randomly or in reaction to a sudden and significant change in the number of reported W-2 employees.

The specific criteria used to discern whether an individual is an employee or an IC depends upon which government agency is researching the situation. But beware: It is not uncommon for one office to get others involved, and their conclusions are not always consistent!

The focus of any such inquiry is the level of control that the employer holds over the individual. It is important to note that whether this control is actually exerted is irrelevant; what really matters is whether the employer could, if it so desired, dictate the details of the individual's work.

The Internal Revenue Service's 20-Factor Control Test is the most explicit in its requirements. The good news is that no single factor is decisive. Rather, the facts and circumstances surrounding all of them must be carefully considered when assessing the degree of control that exists in a given work arrangement.

When determining whether an individual is more appropriately classified as an employee or IC, ask yourself the following questions:

To streamline this analysis, the Internal Revenue Service recently used these factors to develop what is known as the three "categories of evidence" - behavioral, financial, and type of relationship. While intended to assist workers in determining their own appropriate classification, employers may find IRS Publication 1779 (http://www.irs.gov/pub/irs-pdf/p1779.pdf) to be a useful reference in understanding these criteria. Publication 15-A (http://www.irs.gov/pub/irs-pdf/p15a.pdf) is also quite valuable, especially in that it provides scenarios from a variety of industries.

But what if you're only reading this article because of an impending IRS audit? Based on the information presented above, you now believe that your workers are misclassified, but it's too late to change their status now. Is there any chance of avoiding the harsh consequences?

Believe it or not, the answer is yes. Your business may qualify for an IRS Section 530 "safe harbor" exception if you can substantiate all three of the following relief requirements:

  1. You had a reasonable basis for classifying the individuals as ICs. For example:

    • You relied on a relevant court case, IRS ruling, or the advice of a qualified accountant or attorney;

    • The IRS did not reclassify these or similar workers during an earlier audit; or

    • It is a standard industry practice to treat certain types of workers as ICs.

  2. You have consistently treated these and all similar workers as ICs in the past.

  3. You have consistently filed federal tax returns (Form 1099-Misc.) for these and all similar workers.

Going forward, there are several measures you can take to safeguard against allegations of misclassification:

  • Consider engaging only those ICs that are incorporated and, as a result, have been assigned a federal tax ID number. By establishing a "corp-to-corp" relationship, the burden is shifted away from your organization because the individual is considered an employee of his or her own corporate entity.

  • Keep IC files separate from employee files. Manage IC files as you would those of any other outside vendor.

  • Require that ICs submit invoices for services rendered prior to processing payment. Collect documentation that supports the individual's IC status, such as business cards, yellow page listings, marketing collateral, etc.

  • Refrain from asking ICs to complete standard "new hire paperwork" such as an employment application and I-9 (immigration) form. Additionally, do not provide them with an employee handbook.

  • Avoid having ICs and W-2 employees work "side-by-side" (i.e., performing the same tasks and reporting to the same managers).

  • Develop a contract that explicitly reflects the 20 factors described above, with an emphasis on the following points:

    • The agreement is limited to a specific term or project and will not automatically "roll over."

    • The IC will determine how the work will be accomplished.

    • The IC is not prohibited from providing the same or similar services to other companies during the course of the relationship.

    • The IC is not covered by the organization's liability, health and worker compensation insurance.

While adhering to IRS guidelines may reduce some of your staffing flexibility, the short-term inconvenience is far less unpleasant than the long-term repercussions of being found non-compliant. That said, the IRS will gladly help you determine the appropriate classification for a worker or group of workers in your organization. Simply complete and submit Form SS-8 (http://www.irs.gov/pub/irs-pdf/fss8.pdf).


Christina Morfeld is president of Affinity Business Communications, a provider of high-quality instructional design, technical writing, and content development solutions. Whether writing to instruct, inform, or persuade, our work is reader-focused, benefits-oriented, and results-driven. Contact us at 203-445-9964 or info@affinitybizcomm.com, or visit our website at http://www.affinitybizcomm.com to learn how we can increase your firm's sales and effectiveness!

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Copyright 2001-2003 Christina Morfeld and Affinity Business Communications, LLC.
Originally published by Suite101.com. All rights reserved.

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