Worker classification questions—that is, deciding whether to hire people as employees or independent contractors—are always a hot-button issue with the IRS. The rules are complex and to some extent open to interpretation, and the penalties for getting it wrong are substantial.
For many years the IRS used a list of questions known as the “20 Factor” test to help companies determine worker classification. A few years ago, it consolidated the list and organized it into three categories:
1) Behavioral control – How closely does the company direct and control how the worker does the job? Generally speaking, if the company controls both what is to be done and how it is to be done, the workers involved are probably employees. If the company controls only the result of the work, not the means and methods of accomplishing it, there’s a possibility the workers could be classified as independent contractors. Key indicators include instructions about the order or sequence of individual tasks, where materials are purchased, and any training that is provided.
2) Financial control – How much does the company control the business aspects of the relationship? Critical issues include how and whether expenses are reimbursed, whether the worker has any financial investment in the job, and whether the worker also offers services to other businesses.
3) Type of relationship – How do the two parties perceive their work arrangements? Written contracts help determine this issue. Other relevant factors include the provision of employee-type benefits such as insurance, paid vacations, and sick pay, all of which indicate the worker is an employee, not a contractor.
IRS Publication 15-A, the Employer’s Supplemental Tax Guide, offers several examples of specific construction industry scenarios involving the use of independent contractors.