The IRS 20 Factor Test: Independent Contractor or Employee?

When hiring a person, it is vital to determine whether the person can be classified as an independent contractor or an employee. Many factors determine that, which we discussed in the contractor vs employee article. In this guide, however, we will focus on the IRS 20 Factor Test and how it can help employers and employees understand the worker status and classify it correctly.

Who is considered an independent contractor

An independent contractor is a service provider who agrees with an employer to provide requested services on a need or project basis. This individual is not directed or controlled by the employer regarding the performance of their work.

Independent contractors have greater control over how and when they carry out their work compared to employees. Companies don't provide payments for the worker's business expenses, just a lump sum fee for their services.

Various laws apply to the employer-employee relationship that are generally not applicable to independent contractors. Pension, workers' compensation, social security, and wage and hour law are some of the things that cannot be offered to an independent contractor. However, independent contractors can be awarded a bonus. When it comes to tax withholding, employees are not obliged to withhold federal, state, and local taxes. Independent contractors are usually responsible for filing their own taxes.

There are many benefits to the independent contractor relationship, but every company must determine if this relationship is applicable carefully. The risk of misclassification is tremendous and can result in back taxes or premiums, civil fines, interest, and other retroactive damages.

The IRS created guidelines to help employers to classify their employment relationships correctly. The IRS follows the common law test when determining whether an individual is an employee for federal employment tax purposes.

The Reasonable Basis test

The "Reasonable Basis" test serves as an excellent tool for employers, which prevents the IRS from challenging the status of an individual as an independent contractor if certain conditions are met. In that case, the employer does not have a tax liability for workers under Section 503, and the IRS cannot penalize them for misclassification.

• An individual has always been treated as an independent contractor by the employer.
• The employer has filed all returns for the individual for all periods after 1978, and the independent contractor status was consistent.
• The employer had a reasonable basis for treating an individual as an independent contractor by either relying on judicial precedent, published rulings, a prior IRS audit showing no penalties assessed for similarly situated individuals, or a longstanding recognized practice of a significant segment of the industry in which the individual worked.

The IRS designed the 20-Factor Test to help employers assess whether a worker is considered an employee or an independent contractor. No one factor is more important or indicative of employee status. It would be best if you looked at things holistically. If there are more "Yes" answers than "No," then there is a significant risk of employment relationship presence.

If an employer is unsure even after taking the test, we advise pursuing the IRS ruling. This is done by filing a Form SS-8 (Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding) to the IRS.

The IRS 20-Factor test

1. Instructions: Is the worker required to comply with the employer’s instructions about when, where, and how to work?
2. Training: Is training required? Does the worker receive training from or at the employer's direction, including attending meetings and working with experienced employees?
3. Integration in business operation: Are the worker’s services integrated with the activities of the company? Does the success of the employer’s business significantly depend upon the performance of services that the worker provides?
4. Services Rendered Personally: Is the worker required to perform the work personally?
5. Authority to hire assistants: Does the worker have the option of hiring, supervising, and paying assistants for the employer? Does the company influence the hiring and payment of the worker's assistants?
6. Continuing Relationship: Does the worker have a continuing relationship with the employer?
7. Set Hours of Work: Is the worker required to follow set hours of work?
8. Full-time Work Required: Does the worker work full-time for the employer?
9. Place of Work: Does the worker perform work on the employer’s premises and use the company’s office equipment?
10. Sequence of Work: Does the worker perform work in a sequence set by the employer? Does the worker follow a set schedule?
11. Oral or Written Reports Obligations: Does the worker submit regular written or oral reports to the employer?
12. Method of Payment: How does the worker receive payments? Are there payments of regular amounts at set intervals?
13. Payment of Business and Travel Expenses: Does the worker receive payment for business and travel expenses?
14. Furnishing of tools and materials: Does the worker rely on the employer for significant tools and materials?
15. Investment: Has the worker made a significant investment in the facilities or equipment used to perform services?
16. Realization of Profit or Loss: Is the payment made to the worker on a fixed basis regardless of profitability or loss?
17. Working for more than one company at a time: Does the worker only work for one employer at a time?
18. Availability of services to the general public: Are the services offered to the employer unavailable to the general public?
19. Right to discharge: Can the worker be fired by the employer?
20. Right to quit: Can the worker quit work at any time without liability?