Generally, a worker may be classified as an independent contractor if the employer has the right to control or direct the result of the work but not the means or methods of accomplishing the result. The Internal Revenue Service (IRS) uses a 20-factor test to determine whether a worker is an employee or an independent contractor. No one factor is determinative, and the nature of the company’s business, as well as the industry standard, are taken into account. The 20 factors listed by the IRS include:
- Is the worker free from company control regarding how, when, and where the work is done?
- Does the company or the worker decide the order in which tasks are done?
- Does the worker have the ability to subcontract work, or does the employer hire assistants to help the worker?
- Does the employer or the worker provide the tools, equipment, and/or supplies necessary to do the work?
- Does the employer provide training for the worker?
- Does the worker receive a salary?
- Can the worker increase his or her financial gain by working more efficiently? Conversely, does the worker risk losing money if unexpected problems arise?
- Does the worker provide services to more than one employer or make the services available to the general public?
Possible consequences of misclassifying a worker
If the IRS determines an employer intentionally misclassified an employee as an independent contractor, the employer can be held liable for the taxes it should have paid or withheld for the recategorized worker. Furthermore, the IRS can assess penalties and interest for up to 3 prior years. In cases in which the statute of limitations does not apply, assessments can be made for an unlimited number of prior years.
Employer’s defense strategy
An employer may qualify for Section 530 relief, which allows an employer to escape liability for past and future employment taxes, even if its worker should have been treated as an employee under the law. To qualify for the relief, an employer must have:
- A reasonable basis for treating the worker as a contractor (e.g., standard industry practice)
- Filed Form 1099s annually for the worker, that is, consistently treated the worker as an independent contractor
- Treated all similarly situated workers in a consistent manner
In addition, the Small Business Job Protection Act of 1996 enhanced section 530 relief in the following three ways:
- It requires the IRS to inform an employer of its right to seek section 530 relief.
- It states that independent contractor status is permitted if it is “a standard industry practice.” (A practice is considered standard in an industry if 25% of the industry follows it.)
- It shifts the burden of proof to the IRS, after the employer makes an initial showing that it had reasonable grounds for believing contractor status was appropriate.
Decreasing your chances of an audit
The IRS might question an employer’s classification if:
- The employer reports more independent contractor compensation than is standard in the industry.
- A worker used to receive W-2s and now receives 1099s.
- A worker’s income tax return shows he or she received 1099 income from only one employer.
None of these situations is impermissible, but an employer should be ready to defend its classification if one or more of these circumstances apply to its independent contractors. An employer should always keep in mind the 20-factor test, and make sure that its independent contractor agreements are in line with it. An employer also can ensure it will be eligible for section 530 relief by filing 1099s for independent contractors, documenting how its practices follow industry standards, and treating all similarly situated employees in a consistent manner.
By American Institute of Certified Public Accountants
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