Determining employee or independent contractor status

The IRS Test Many people still think of the 20 questions test, based on right of control, to determine a worker’s status as an employee or independent contractor.  The IRS, however, thought it would be easier to consider three categories, known as “BFR”:  behavioral control, financial control and relationship of the parties.

Behavioral Control addresses whether a business can direct or control how the worker does the job.  An employee is subject to the business’s instructions as to when, where and how to do the work.  This could include:

  • When and where to do the work;
  • What tools or equipment to use;
  • What workers to hire or to assist with the work;
  • Where to purchase supplies and materials;
  • What work must be performed by a specified individual;
  • What sequence or order to follow;
  • Training provided.

The more detailed the instructions, the more control exists, indicating the worker is an employee.  On the other hand, the less detailed the instructions, the less control exists, indicating the worker is an independent contractor.  On the job training is strongly indicative of an employee.

Financial Control indicates whether the payer can control the business aspects of the worker’s job.  This could include:

  • Significant investment in the business;
  • Unreimbursed business expenses;
  • Opportunity for profit or loss;
  • Services available to others;
  • Method of payment.

A worker may spend thousands of dollars on tools and equipment but still be considered an employee in some occupations such as construction.  It is more likely that independent contractors have unreimbursed business expenses.  The possibility of losing money on a job due to large business purchases and unreimbursed expenses indicates a worker is an independent contractor.  An employee generally does not advertise, have a business location and work for multiple businesses.  Usually a guaranteed hourly or weekly wage is indicative of an employee while a flat fee for a job is indicative of an independent contractor, but there are exceptions.

Relationship of the Parties shows how the worker and business relate to each other.  This could include:

  • Written contracts;
  • Employee type benefits (i.e. pension plan, health insurance, vacations);
  • Permanency of the relationship;
  • Services provided as a key aspect of the business.

Having a written contract is not sufficient to determine a worker’s status, however, it helps to establish an independent contractor relationship.  Generally, businesses do not offer employee benefits to independent contractors.  Expectation of continuing a relationship indefinitely rather than for a specific project indicates an employer-employee relationship.  If a worker’s services are key to the business, the worker is more likely an employee.

Consequences of Erroneous Classification
If the IRS subsequently determines that a worker is an employee rather than an independent contractor, the employer is subject to penalties for failure to withhold income tax (1.5%-3% of the individual’s wages) and FICA tax penalty (20%-40% of the employee’s share), must pay its share of the FICA tax and must pay unemployment taxes plus penalties and interest.  Criminal and civil penalties may be assessed.  Misclassification could also result in having employee benefit plans invalidated or requiring retroactive funding changes.  If the IRS determines that an employer intentionally misclassified workers, it can hold business owners and officers personally responsible with a 100 percent penalty.  Issuing Forms 1099 prevent the higher penalties and are key to receiving Section 530 Relief.

Finally, re-characterized workers should also file amended tax returns.

The States Tests
Many states, however, adopt a stricter test than the IRS test to address the issues of unemployment insurance and worker’s compensation.  Known as the “ABC” test, most states consider an individual working for an employer to be an employee unless they satisfy three elements. 

  • Worker must be free from direction and control over performance of the work;
  • Worker must usually be engaged in an established trade or business that is of the type of work being performed;
  • Work performed is outside the employer’s usual course of business or outside the employer’s place of business.

Conclusion A business must look at the relationship, consider the right to direct and control, and document the factors used to reach their determination as to classification.  Ultimately, the determination is not that of the employer but rather that of state and/or federal authorities.  The tests apply to all businesses regardless of the industry.  The final determination is a question of facts and circumstances, reached on a case by case basis.  One should consult an attorney and accountant to address other issues which may also result in severe consequences for misclassification.

For further information, refer to for Publications 15-A, 1779, 1976. Examples are provided in IRS Publication 15-A Employer’s Supplemental Tax Guide to help properly classify workers in the following industries:  building and construction industry, trucking industry, computer industry, automobile industry, attorney, taxicab driver and salesperson.

Building and Construction Industry

Example 1. Jerry Jones has an agreement with Wilma White to supervise the remodeling of her house. She did not advance funds to help him carry on the work. She makes direct payments to the suppliers for all necessary materials. She carries liability and workers' compensation insurance covering Jerry and others that he engaged to assist him. She pays them an hourly rate and exercises al-most constant supervision over the work. Jerry is not free to transfer his assistants to other jobs. He may not work on other jobs while working for Wilma. He assumes no responsibility to complete the work and will incur no contractual liability if he fails to do so. He and his assistants perform personal services for hourly wages. Jerry Jones and his assistants are employees of Wilma White.

Example 2. Milton Manning, an experienced tile setter, orally agreed with a corporation to perform full-time services at construction sites. He uses his own tools and performs services in the order designated by the corporation and according to its specifications. The corporation supplies all materials, makes frequent inspections of his work, pays him on a piecework basis, and carries workers' compensation insurance on him. He does not have a place of business or hold himself out to perform similar services for others. Either party can end the services at any time. Milton Manning is an employee of the corporation.

Example 3. Wallace Black agreed with the Sawdust Co. to supply the construction labor for a group of houses. The company agreed to pay all construction costs. How-ever, he supplies all the tools and equipment. He per-forms personal services as a carpenter and mechanic for an hourly wage. He also acts as superintendent and foreman and engages other individuals to assist him. The company has the right to select, approve, or discharge any helper. A company representative makes frequent inspections of the construction site. When a house is finished, Wallace is paid a certain percentage of its costs. He is not responsible for faults, defects of construction, or wasteful operation. At the end of each week, he presents the company with a statement of the amount that he has spent, including the payroll. The company gives him a check for that amount from which he pays the assistants, although he is not personally liable for their wages. Wallace Black and his assistants are employees of the Saw-dust Co.

Example 4. Bill Plum contracted with Elm Corporation to complete the roofing on a housing complex. A signed contract established a flat amount for the services rendered by Bill Plum. Bill is a licensed roofer and carries workers' compensation and liability insurance under the business name, Plum Roofing. He hires his own roofers who are treated as employees for federal employment tax purposes. If there is a problem with the roofing work, Plum Roofing is responsible for paying for any repairs. Bill Plum, doing business as Plum Roofing, is an independent contractor.

Example 5. Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies that she obtained through advertisements. Vera is an independent contractor.

Trucking Industry

Example. Rose Trucking contracts to deliver material for Forest, Inc., at $140 per ton. Rose Trucking is not paid for any articles that are not delivered. At times, Jan Rose, who operates as Rose Trucking, may also lease another truck and engage a driver to complete the contract. All operating expenses, including insurance coverage, are paid by Jan Rose. All equipment is owned or rented by Jan and she is responsible for all maintenance. None of the drivers are provided by Forest, Inc. Jan Rose, operating as Rose Trucking, is an independent contractor.

Computer Industry

Example. Steve Smith, a computer programmer, is laid off when Megabyte, Inc., downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It is not clear how long that it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay federal and state taxes, and receives no benefits from Megabyte. Megabyte will file Form 1099-MISC, Miscellaneous Income, to report the amount paid to Steve. Steve works at home and is not expected or allowed to attend meetings of the software development group. Steve is an independent contractor.

Automobile Industry

Example 1. Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works six days a week and is on duty in Bob's showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager's approval. Lists of prospective customers belong to the dealer. She is required to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.

Example 2. Sam Sparks performs auto repair services in the repair department of an auto sales company. He works regular hours and is paid on a percentage basis. He has no investment in the repair department. The sales company supplies all facilities, repair parts, and supplies; issues instructions on the amounts to be charged, parts to be used, and the time for completion of each job; and checks all estimates and repair orders. Sam is an employee of the sales company.

Example 3. An auto sales agency furnishes space for Helen Bach to perform auto repair services. She provides her own tools, equipment, and supplies. She seeks out business from insurance adjusters and other individuals and does all of the body and paint work that comes to the agency. She hires and discharges her own helpers, determines her own and her helpers' working hours, quotes prices for repair work, makes all necessary adjustments, assumes all losses from uncollectible accounts, and receives, as compensation for her services, a large percentage of the gross collections from the auto repair shop. Helen is an independent contractor and the helpers are her employees.


Example. Donna Yuma is a sole practitioner who rents office space and pays for the following items: telephone, computer, on-line legal research linkup, fax machine, and photocopier. Donna buys office supplies and pays bar dues and membership dues for three other professional organizations. Donna has a part-time receptionist who also does the bookkeeping. She pays the receptionist, withholds and pays federal and state employment taxes, and files a Form W-2 each year. For the past 2 years, Donna has had only three clients, corporations with which there have been long-standing relationships. Donna charges the corporations an hourly rate for her services, sending monthly bills detailing the work performed for the prior month. The bills include charges for long distance calls, on-line research time, fax charges, photocopies, postage, and travel, costs for which the corporations have agreed to reimburse her. Donna is an independent contractor.

Taxicab Driver

Example. Tom Spruce rents a cab from Taft Cab Co. for $150 per day. He pays the costs of maintaining and operating the cab. Tom Spruce keeps all fares that he receives from customers. Although he receives the benefit of Taft's two-way radio communication equipment, dispatcher, and advertising, these items benefit both Taft and Tom Spruce. Tom Spruce is an independent contractor.


To determine whether salespersons are employees under the usual common-law rules, you must evaluate each individual case. If a salesperson who works for you does not meet the tests for a common-law employee, discussed earlier in this section, you do not have to withhold federal income tax from his or her pay (see Statutory Employees in section 1). However, even if a salesperson is not an employee under the usual common-law rules for income tax withholding, his or her pay may still be subject to social security, Medicare, and FUTA taxes as a statutory employee.
To determine whether a salesperson is an employee for social security, Medicare, and FUTA tax purposes, the salesperson must meet all eight elements of the statutory employee test. A salesperson is a statutory employee for social security, Medicare, and FUTA tax purposes if he or she:

  • Works full time for one person or company except, possibly, for sideline sales activities on behalf of some other person,
  • Sells on behalf of, and turns his or her orders over to, the person or company for which he or she works,
  • Sells to wholesalers, retailers, contractors, or opera-tors of hotels, restaurants, or similar establishments,
  • Sells merchandise for resale, or supplies for use in the customer's business,
  • Agrees to do substantially all of this work personally,
  • Has no substantial investment in the facilities used to do the work, other than in facilities for transportation,
  • Maintains a continuing relationship with the person or company for which he or she works, and
  • Is not an employee under common-law rules.

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