IRS Contractor Guidelines Explained

An independent contractor is someone who performs a service for your business, but is not considered to be an employee by federal or state tax authorities. When you use the services of an independent contractor, you do not have to pay employer taxes, process payroll checks, and withhold employee tax shares on behalf of the contractor.

In the United States, however, the IRS and state revenue departments are vigorously trying to minimize lost revenue by carefully examining the status of “independent contractors” at many firms. If your “independent contractors” are deemed employees by the tax authorities, you could be forced to pay back taxes, employee benefits, interest, and penalties.

Many, many businesses of all sizes ignore the IRS guidelines and consider many hires to be independent contractors when they should clearly be employees. You should not do this. For one, the IRS can come after you for unpaid tax liability, interest, and penalties. The tax bill could be sky high! For another, it is not fair to all the other companies and employees who pay their fair share of taxes.

How Do I Determine Whether Someone Is an Employee or an Independent Contractor According to the IRS?

In determining whether the person providing service is an employee or an independent contractor, you must consider all information that provides evidence of the person’s degree of control and independence in performing his or her work.

Businesses must weigh all three of the following factors when determining whether a worker is an employee or an independent contractor. Some factors may indicate that the worker is an employee, while other factors may indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors that are relevant in one situation may not be relevant in another. In other words, weighing these three factors together is more of an art than a science. However, to an experienced businessperson, and certainly to a good employment attorney, there are very clearly allowable and not allowable factors for independent contractor status.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

Factors That Provide Evidence of the Degree of Control and Independence Fall into Three Categories:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer?
  3. Type of Relationship: Are there written contracts or employee-type benefits (i.e., pension plan, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Example of Independent Contractor Under IRS Rules

I hire Joe to build a toolshed for me. I tell him he can work any hours he wants as long as he completes it in one month. The final result must match my plans, but otherwise Joe can perform the work any way he chooses. (This passes the Behavioral Test.)

I tell Joe I will pay him $1,500 to build the shed regardless of how long it takes him. Furthermore, Joe will have to pay for materials out of this amount and he will have to use his own tools. (This passes the Financial Test.)

I tell Joe that this is a onetime job for the time being; there will not necessarily be ongoing work, and there will be no benefits beyond the $1,500 fee. (This passes the Type of Relationship Test.)

Example of Employee Under IRS Rules

I hire Joanne to build a toolshed for me. I tell her I expect her to start work at 9 a.m. every day and work until 4 p.m. I tell her that every day at 9 a.m. I will give her specific instructions on what aspect of the shed to work on that day. I will also give her specific instructions of how I want the work to be done. (This fails the Behavioral Test.)

I tell Joanne I expect the shed to cost about $1,500 in total, including about $1,200 for her labor and about $300 for materials. I will pay her $30 per hour and I expect her to complete the shed in about 40 hours. However, I will still pay her $30 per hour whether it takes more or less time to complete the shed. I will provide all of the materials for the shed and I will provide the tools to build the shed. (This fails the Financial Test.)

I tell Joanne that this is a onetime job for the time being; there will not necessarily be ongoing work, and there will be no benefits beyond hourly rate of pay. (This passes the Type of Relationship Test.)

Even thought Joanne “passed” the Type of Relationship test, she decisively “failed” both the Behavioral Test and the Financial Test. Joanne is clearly an employee.

Suppose I have Joanne sign a contract for her work and that the contract specifies she is an “independent contractor.” Doesn’t matter. The IRS puts little, if any, weight on the contract and would clearly consider Joanne an employee.

State versus IRS Independent Contractor Rules

Some states have enacted rules of their own to determine whether an employee is an independent contractor. They do this specifically to make it more difficult for businesses to legally qualify employees as independent contractors. Massachusetts, for example, a typical anti-business state, has its own very tough three-part rule and workers must satisfy all three parts to qualify as independent contractors.

As a business, you are subject to both the state and the federal rules. The state government can come after you for tax violations if you violate their rules and the federal government can come after you if you violate their rules.

What’s the Bottom Line on Independent Contractors versus Employee Classification?

If in doubt, classify the person as an employee. If possible, shift the work to a state where independent contractor laws are less rigid. The tax penalties are too large to risk otherwise. Furthermore, if a person who was incorrectly classified as an independent contractor gets injured while working for you, then you will have a serious problem because you will have no worker’s compensation insurance for him or her.

Form SS-8

If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” can be filed with the IRS, and may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status. Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing Form SS-8.

About Bob Adams

Bob Adams is a Harvard MBA serial entrepreneur. He has started over a dozen businesses including one that he launched with $1500 and sold for $40 million. He has written 17 books and created 52 online courses for entrepreneurs. Bob also founded BusinessTown, the go-to learning platform for starting and running a business.