Independent contractor or employee? What does the IRS say?

By: Michelle Higgins

Publication: Benefits & Compensation Regulatory Alert

Date Posted: 12/16/2021

Classify a worker as an independent contractor or an employee

Knowing whether to classify a worker as an independent contractor or an employee isn’t easy. Rules are finalized, and sometimes rescinded. Employers must analyze how different agencies define the roles. And this is only at the federal level. State laws could also come into play.

From a federal perspective, however, when it comes to employment law, generally employers look to the Department of Labor (DOL) for direction on this topic. But the Internal Revenue Service (IRS) also has a say in how “independent contractor” is defined.

This past fall during National Small Business Week, the IRS reminded business owners that it’s critical to correctly determine whether the individuals providing services are employees or independent contractors.

What does the IRS say?

The IRS states that an employee is generally considered to be anyone who performs services, especially if a company can control what will be done and how it will be done. What matters is that the business has the right to control the details of how the worker’s services are performed.

According to the IRS, independent contractors are normally people in an independent trade, business, or profession in which they offer their services to the public.

Whether a worker is an independent contractor or an employee, per the IRS, depends on the relationship between the worker and the company.

Generally, there are three categories the IRS examines:

  • Behavioral control. Does the company control or have the right to control what the worker does and how the worker does the job?
  • Financial control. Does the company direct or control the financial and business aspects of the worker’s job? Are the business aspects of the worker’s job controlled by the company paying the worker? (This could include how the worker is paid, reimbursement of expenses, who provides tools/supplies, etc.)
  • Relationship of the parties. Are there written contracts or employee type benefits (pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

The IRS states that misclassifying workers as independent contractors adversely affects employees because the employer’s share of taxes is not paid, and the employee’s share is not withheld.

If a business misclassified an employee without a reasonable basis, it could be held liable for employment taxes for that worker. Generally, an employer must withhold income taxes, social security, and Medicare taxes, as well as pay unemployment taxes.

What does the DOL say?

Employers might recall that in May 2021, the DOL withdrew the Independent Contractor Final Rule under the Fair Labor Standards Act (FLSA).

The DOL, however, didn’t replace it with any new guidance. Until they do, employers are left looking to old guidance and case law, which can be inconsistent.

According to DOL Fact Sheet #13, seven key FLSA factors to consider include:

Independent workers statistics

  1. The extent to which the services rendered are an integral part of the principal’s business.
  2. The permanency of the relationship.
  3. The amount of the alleged contractor’s investment in facilities and equipment.
  4. The nature and degree of control by the principal.
  5. The alleged contractor’s opportunities for profit and loss.
  6. The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
  7. The degree of independent business organization and operation.

Working with independent contractors involves a number of responsibilities for employers — from safety to wages and benefits. Employers must look through multiple lenses to properly classify workers.

Key to remember: Employers must remember that different agencies may use different criteria to define the employment relationship. Thus, what one agency may define as an independent contractor relationship, another might define as an employer/employee relationship.

About the author
Michelle Higgins - Human Resources Editor

Michelle Higgins is an Associate Editor on the Human Resources Publishing Team at J. J. Keller and she creates content on a variety of employment-related topics including benefits, compensation, overtime, wage deductions, exempt/nonexempt employees, health and retirement plans, independent contractors, and child labor.

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