I am frequently asked by established organizations and start-up companies, alike, whether a new hire is an independent contractor or an employee. In a previous post I discussed the determination under California law. This post covers the relevant IRS determination under federal law.
In my experience as an attorney drafting business contracts, proper classification is important to avoid state and federal tax penalties as well as lawsuits by workers. Employers generally must withhold Social Security, Medicare, income and unemployment tax on wages paid to an employee; whereas, no taxes are typically withheld on wages paid to an independent contractor.
Unfortunately, making the determination as to employee or independent contractor status, while important, can be complicated as there are multiple factors under California employment law to be considered and separate tests under California and federal law.
The IRS's Multi-Factor Test
Like California, the IRS also has a multi-factor test to determine whether a worker is an employee or an independent contractor.
Where an employer has the right to control the means and manner in which the job is performed, the worker would likely be deemed an employee. For example, the right to control and direct is often found where the worker is given instructions as to where, when or how to perform the job or what equipment is to be used.
In addition to behavioral factors, there are also financial elements to a working relationship that help determine whether a worker is an employee or an independent contractor.
For example, where a worker has a substantial investment in the work, the worker is more likely to be an independent contractor. While there is no set limit on the dollar amount required, the investment must be "of substance." Substantial investment is merely a factor in this test--a worker can still be an independent contractor even when he or she has not made a substantial investment in the work.
In addition, where an employer does not reimburse the worker for business expenses, that worker is more likely to be an independent contractor.
Finally, if a worker can realize a profit or loss, then the worker is more likely to be an independent contractor.
The final set of factors relate to how the employer and worker perceive their working relationship.
The clearest indication of how an employer and worker perceive the relationship is often set forth in a written contract. Where the above factors do not establish a clear picture of the working relationship, the existence and clarity of a written agreement can often provide a determination of whether the worker is an employee or not.
Lastly, whether a worker is given benefits, such as health insurance or retirement benefits, is also a factor that the IRS considers when making this determination. Independent contractors are not typically given benefits.
It is important to remember that both the federal and California multi-factor test must be considered. Although the federal and state tests may seem similar, they are not in fact the same.
For related reading on employee versus independent contractor legal issues review the following posts on this blog:
San Francisco Business Contract Attorney Matthew L. Kabak provides legal advice and counsel to start-up companies and established organizations on employee classification and business litigation issues and has served San Francisco, Palo Alto, San Jose and the greater San Francisco Bay Area for over a decade.