Defining independent contractors

With growing acceptance of flexible work arrangements among large and small employers, many, including seasonal employers, are increasing their contingent hiring to meet the peaks and valleys of demand. A 2007 Staffing Buyers Survey estimates that the contingent workforce will grow to 10 percent of all U.S. workers in two years, CCH reports.

Classifying contingent workers as independent contractors benefits employers because it reduces recruiting and training costs, CCH says. These employers also save money on benefits packages and payroll taxes, a result that has the attention of the Internal Revenue Service (IRS) and state tax authorities, who question how independent many of these workers really are.

Minnesota has adopted one approach to increasing employment tax compliance. In 2009 workers who claim independent contractor status will be required to prove that they are independent. A recent report by the state's Office of the Legislative Auditor estimates that 14 percent of employers misclassify workers as independent who really meet the state's definition of a regular employee, says. Many independent contractors in the state work in construction.

Varying state and federal criteria for independent contractor status which are "complex, subjective and different from law to law" complicate enforcement, CCH says. The IRS test varies from the Department of Labor's standards and some employment law tests of status.

In an effort to clarify its standards, the IRS, which was successful in claiming that Fedex misclassified its more than 15,000 drivers as independent contractors, published the fact sheet, "Employment Taxes and Worker Classification," in its Tax Gap series in December. The fact sheet focuses on the level of control the worker has in the performance of his or her job. "Generally the more control the business has over a worker, the more likely it is that the worker is an employee rather than an independent contractor," the fact sheet says.

Three types of control are significant in employment, according to the IRS: behavioral control, financial control, and type of relationship.

When evaluating the level of behavioral control, the agency asks whether the employer or the worker controls the details of how the services are performed, including:

  • Where and where to do the work

  • What tools or equipment to use

  • What workers to hire and or to assist with the work

  • Where to purchase supplies and services

  • What work must be performed by a specified individual

  • What order or sequence to follow

    The IRS standard for financial independence involves questions about whether workers participate in or make financial decisions that will affect their bottom line, whether they have a financial investment (own their tools, for example), and how they are paid.

    An employer-employee relationship might exist, the IRS fact sheet says, when a worker has a contract with an employer or when the worker receives some benefit.

    Enforcing worker classification rules will require cooperation and coordination between state and federal taxing authorities, a principal goal of the Questionable Employment Tax Practices (QETP) initiative in which the IRS, the Department of Labor, and state taxing authorities are participants.

    Late in 2007, The IRS agreed with 29 states to share employment tax information through a memorandum of understanding (MOU) developed by the QETP. According to a report on the Small Business Taxes & Management web site, the agreement provides that "the IRS and the states will strive to be consistent with their examination results, reducing the chances that states might classify a worker as an employee while the IRS classifies the worker as an independent contractor, or vice versa."

    Other areas where the IRS and the states have agreed to cooperate include:

  • The IRS and the participating state workforce agencies will exchange employment tax information for civil cases primarily in which the employers are attempting to evade or inappropriately reduce employment tax liabilities.

  • The IRS and the states may exchange information using either actual employment tax reports or a template compatible with federal and state information that the oversight team has developed.

  • The IRS and the states may participate in coordinated enforcement efforts. The MOU will allow the IRS and the state workforce agencies to share independently conducted examination results or work side by side on an examination.

  • The IRS and the states will share employment tax training opportunities and materials.

  • The IRS and the states will share outreach opportunities to the business community whenever practical.
    The MOU acknowledges privacy concerns and goes on to say that "all participating states must demonstrate they have systems in place to ensure the safety of any IRS data they receive as a part of the information exchange agreement."

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