As a business owner, how do you classify the people who work for you? Are they independent contractors or employees? The classification is important and can be scrutinized by the Internal Revenue Service (IRS) and others.

The distinction between an employee and an independent contractor is important for several reasons. The following are a few areas of importance:

• Impacts tax liability
• Impacts liability
• Impacts workers compensation issues

Many times, as businesses hire workers, they may classify the worker as an employee. Typically, employees follow orders, direction or supervision from the employer. Employees also receive regular paychecks, work year round and their actions are controlled by the employer.

As an independent contractor, the worker typically completes the work in a manner they prefer, they are paid by the job, are temporarily employed, and the method, manner and means of completing the work is determined by the independent contractor.

National Research Project by the IRS
The IRS is interested in how workers are classified due to the apparent loss of revenue which the IRS believes it is missing. Due to the apparent loss of revenue, the IRS has begun a national research project to collect data to assist the IRS to focus on areas where mistakes are most likely to occur and focus attention to those most likely to have erred. This project will randomly select 2000 small, large and self employed taxpayers to examine their employment tax returns each for the years 2010-2012.

The research project will focus on the following 4 areas: worker classification, fringe benefits, compensation of company principals and reviews of 1099s.

Recent IRS Break for Employers
The IRS recently announced a new program entitled the “Voluntary Worker Classification Settlement Program. This new initiative provides that the IRS will allow businesses to reclassify workers and make only a small payment to cover past payroll taxes for improper classifications. To be eligible for the program, employers must have consistently treated workers as nonemployees, filed 1099s for the worker for the previous 3 years, and not be under an IRS or worker classification audit.

Classification of Workers
How a worker is classified (employee or independent contractor) can be based on a multiple of factors. The IRS has established its own standards and characteristics for determining whether a worker is an employee or independent contractor. Likewise, many states have established standards as well. The IRS looks at three basic characteristics to help with the classification.

They are:

1. Behavioral Control: does the business have the ability to direct how the work is to be completed? Does the business conduct training, providing instructions, provide a handbook and/or set the guidelines for the relationship?
2. Financial Control: does the business owner have the right to determine the financial portion of the work? Does the business owner control the business portion of the work?
3. Type of Relationship: how does the worker perceive their relationship with the business, as an employee or independent contractor?

The IRS has also determined twenty factors to determine whether the employer can exercise enough control to establish an employer-employee relationship. Not all factors must be present. These are guidelines for the IRS to determine the situation.

They are:

1. Instructions. An employee must comply with instructions about when, where and how to work. The control factor is present if the employer has the right to require compliance with the instructions.
2. Training. An employee receives on-going training from, or at the direction of, the employer. Independent contractors use their own methods and receive no training from the purchasers of their services.
3. Integration. An employee’s services are integrated into the business operations because the services are important to the business. This shows that the worker is subject to direction and control of the employer.
4. Services rendered personally. If the services must be rendered personally, presumably the employer is interested in the methods used to accomplish the work as well as the end results. An employee often does not have the ability to assign their work to other employees, an independent contractor may assign the work to others.
5. Hiring, supervising and paying assistants. If an employer hires, supervises and pays assistants, the worker is generally categorized as an employee. An independent contractor hires, supervises and pays assistants under a contract that requires him or her to provide materials and labor and to be responsible only for the result.
6. Continuing relationship. A continuing relationship between the worker and the employer indicates that an employeremployee relationship exists. The IRS has found that a continuing relationship may exist where work is performed at frequently recurring intervals, even if the intervals are irregular.
7. Set hours of work. A worker who has set hours of work established by an employer is generally an employee. An independent contractor sets his/her own schedule.
8. Full time required. An employee normally works full time for an employer. An independent contractor is free to work when and for whom he or she chooses.
9. Work done on premises. Work performed on the premises of the employer for whom the services are performed suggests employer control, and therefore, the worker may be an employee. Independent Contractor may perform the work wherever they desire as long as the contract requirements are performed.
10. Order or sequence set. A worker who must perform services in the order or sequence set by an employer is generally an employee. Independent Contractor performs the work in whatever order or sequence they may desire.
11. Oral or written reports. A requirement that the worker submit regular or written reports to the employer indicates a degree of control by the employer.
12. Payments by hour, week or month. Payments by the hour, week or month generally point to an employer-employee relationship.
13. Payment of expenses. If the employer ordinarily pays the worker’s business and/or travel expenses, the worker is ordinarily an employee.
14. Furnishing of tools and materials. If the employer furnishes significant tools, materials and other equipment by an employer, the worker is generally an employee.
15. Significant investment. If a worker has a significant investment in the facilities where the worker performs services, the worker may be an independent contractor.
16. Profit or loss. If the worker can make a profit or suffer a loss, the worker may be an independent contractor. Employees are typically paid for their time and labor and have no liability for business expenses.
17. Working for more than one firm at a time. If a worker performs services for a multiple of unrelated firms at the same time, the worker may be an independent contractor.
18. Making services available to the general public. If a worker makes his or her services available to the general public on a regular and consistent basis, the worker may be an independent contractor.
19. Right to discharge. The employer’s right to discharge a worker is a factor indicating that the worker is an employee.
20. Right to terminate. If the worker can quit work at any time without incurring liability, the worker is generally an employee. North Carolina Factors for Classification The State of North Carolina has established factors in determining the classification as well. A big factor in North Carolina is the degree to which the employer retains the right to control the work performed.

The following factors are considered whether the performing party:

1. Is engaged in an independent business;
2. Has independent use of special skills, knowledge or training
3. Is performing work for a fixed price or lump sum
4. Is not subject to discharge based on the method of performance
5. Is not in the regular employ of the contracting party
6. Is free to use assistants as needed; and
7. Selects their time to perform the work

Generally, the tests are applied based on a totality of the circumstances. No single factor is totally determining. Are your workers properly classified?

If you have questions about classification of workers, written employment policies or other similar topics, we hope you will contact us.