Independent Contractor or Employee?

What is the TWC 20-point analysis?

Employers are often times looking for ways to lower overhead expenses. Lowering the bottom line is, after all, an effective way to increase net profits. Think about it, if a person is an independent contractor, the employer is no longer responsible for:

a. Social Security (FICA) and Medicare taxes (7.65% of the employee’s wages);
b. Overtime and minimum wage;
c. Employer portion of health insurance premiums;
d. Retirement benefits;
e. Vacation pay;
f. Holiday pay;
g. Workers’ compensation insurance premiums; or
h. The general administrative headache of payroll.

One of the common ways of doing this is to structure an independent contractor model with people who may otherwise be considered employees. This makes sense, of course, because it shifts the tax burden of wages paid entirely on the employee/independent contractor.

The benefit is not entirely one-sided. The shift from W-2 wages to 1099 contractor payments removes the requirement of the employer to withhold earnings from the employee to divert to the IRS thus increasing the amount directly paid to the contractor and a savvy taxpayer may enjoy the fruits of delaying payment to the IRS of their annual tax liability by sound investing or offsetting of earning against losses elsewhere.

The idea, of course, is that, in the end, the IRS will receive their pound of flesh from the contractor rather than the employer when the 1099s are issued and the contractor files their year-end tax return so what’s the harm?

Not unsurprisingly, the IRS and the vast majority of state workforce commissions do not look favorably upon this structure. Amongst other reasons, it is a much simpler proposition for the IRS to collect tax revenue from the source of the payments (the employer) than to chase down the numerous employees/independent contractors.

According to the IRS, the general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. In determining the level of control applied in any particular circumstance, the IRS will analyze evidence in three categories: 1) Behavioral Control, 2) Financial Control, and 3) Type of Relationship.

Similarly, the Texas Workforce Commission (TWC), who regulates unemployment collection and payment, applies the Texas Unemployment Compensation Act (TUCA) definition of employment and an individual is considered an employee if they perform services for wages under an express or implied contract for hire, unless it is shown to the satisfaction of the TWC that the individual’s performance of the services has been and will continue to be free from control or direction under the contract.

The three essential elements of the definition of employment are service, wages, and direction and control. Direction and control can be present in an employment relationship even if the employer does not exercise direction and control, but retains the right to do so. The TWC uses a 20-point comparative approach to determine if a worker is an employee or independent contractor.

What is the IRS 20 Factor Test?

Looking first to the IRS’s analysis it is imperative to note that there is no bright line rule for whether or not a person is an employee or an independent contractor and, with certain exceptions, the analysis will find many arguments for either interpretation of the relationship. The ultimate result of a review by the IRS will hinge on the interpretation of the investigating agent and there is no guarantee how and analysis will play out. The following are factors they will consider before making their final conclusion:

Behavioral Control:

The IRS will first look to behavioral control, which refers to facts that show whether there is a right to direct or control how the worker does the work. A worker will be considered an employee in the eyes of the IRS when the business has the right to direct and control the worker. Of particular note is that, according to the IRS, the business does not have to actually direct or control the way the work is done, they just need to have the right to control the work.

A more thorough analysis by the IRS will dive into the following categories:

  • Type of instructions given
    • Is a person subject to direction on when, where, and how to work?
        • Examples from the IRS 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 services.
          • What work must be performed by a specified individual.
          • What order or sequence to follow when performing the work.
      • Degree of instruction
        • How detailed are the instructions to the worker?
          • As a general matter, the IRS believes that the more detailed the instructions, the more likely the person is an employee as less detail implies less control.
      • Evaluation systems
        • Is there an evaluation of performance system in place?
          • If so, it may indicate the existence of an employee employer relationship.
      • Training
        • How much, if any, training is being provided to the worker?
          • If there is substantive training involved, the IRS may find that an employee/employer relationship is involved as the belief is that independent contractors will have their own, already established methods for completing a job.

Financial Control:

The IRS will next look to financial control which refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job. Financial control analysis will center around the following categories:

      • Significant investment
        • How much money has been invested into the worker?
          • The general belief is that an independent contractor will have invested money in themselves while an employer will have invested money into an employee. There is no particular dollar amount that will trigger a finding one way or the other here.
      • Unreimbursed expenses
        • Are the worker’s expenses being covered?
          • The general belief is that employee’s expenses are covered where an independent contractor’s are not. This, of course, ignores the presence of time and materials contracts that provide for reimbursement of almost all of a contractor’s expenses.
      • Opportunity for profit or loss
        • Is there a chance the worker may end up losing money on the project?
          • This factor carries relatively heavy weight as an employee is generally compensated a fixed amount for work done and does not stand to either lose money or make money by working on a project. Where there is the possibility that a worker has invested money into materials and labor and may not see all of that money back on a project, the IRS will lean independent contractor.
      • Services available to the market
        • Is the worker bound to work only for one person?
          • As a general matter, independent contractors can work for numerous clients at once.
      • Method of payment
        • How frequently is a worker accumulating fees? Hourly, Weekly, Fixed Fee?
          • As a general matter, amounts earned and or paid in regular increments indicate the existence of an employee/employer relationship. The IRS does, however, acknowledge that certain professions (cough cough…lawyers…) bill by the hour and are still considered independent contractors.

Type of Relationship:

Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. The relationship analysis will center around the following:

    • Written contracts
      • What does your contract say?
        • The IRS is quick to point out that the existence of an independent contractor agreement does not an independent contractor relationship make. Alas, this is still a consideration in the analysis.
    • Employee benefits
      • Are you providing the worker with health insurance? 401K? Pension? Vacation?
        • Few things will end an analysis quicker than the existence of employee benefits.
    • Permanency of the relationship
      • How long will the worker be providing services?
        • Project-to-project relationships tend to favor the finding of an independent contractor relationship whereas as relationship of, say, two years, gives the impression of an employee/employer relationship.
    • Services provided as key activity of the business
      • How vital is the worker to the success of the business?
        • The IRS takes the stance that if a worker is providing a service the business can’t live without, it is more likely that the worker is an employee. This conclusion ignores the reality that, arguably, any service a business hires a contractor to perform is vital to the success of the business otherwise the business would not obtain the service. The instability of this factor is one of the reasons why no one factor is all-deciding in this analysis.

Texas

The Texas Workforce Commission follows a 20-point analysis that contains many of the same logic and analysis of the IRS. The points are laid out by the TWC as follows:

  1. Instructions: Similar to the IRS analysis, the level of instruction provided to a worker will sway the analysis of the TWC. As a general matter, instruction as to when, where, and how will lead to a conclusion of employee status.
  2. Training: Similar to the IRS analysis, the level of training provided to a worker will be considered in establishing the existence of an employer/employee relationship. Generally speaking, more training to the worker indicates employee status.
  3. Integration: In a slight variation of the IRS’ “key activity” analysis, the TWC looks to see how integrated the services of the worker are with the normal business of the company hiring the worker.
  4. Services Rendered Personally: An Employee’s services must be rendered personally; Employees do not hire their own substitutes or delegate work to them. A true Independent Contractor is able to assign another to do the job in his or her place and need not perform services personally.
  5. Hiring, Supervising & Paying Helper: The TWC has taken the position that an employee would not be able to hire someone to perform their tasks whereas an independent contractor can, and often does, subcontract out labor or have employees of their own to perform tasks. Thus, the existence of employees within the employ of the independent contractor sways the analysis heavily towards concluding independent contractor status.
  6. Continuing Relationship: Similar to the IRS analysis, the length of services provided is considered. A project-to-project relationship will indicate the existence of an independent contractor relationship.
  7. Set Hours of Work: Essentially, the rationale is that an independent contractor dictates their own hours. This conclusion, at its core, does not and cannot capture the reality that for many construction projects, the space available to work may only be open for a small window of time and the hours an independent contractor will work may be directed by someone else due to timing.
  8. Full Time Required: This analysis follows the IRS’s review of whether or not the independent contractor is able to work for other parties. This analysis is also redundant as a similar review arises later in the analysis.
  9. Location Where Services Performed: Simply put, if the worker is told where to work, they are an employee. This, of course, does not take into account projects performed on homes or commercial buildings where an independent contractor has no choice. But to work on site.
  10. Order or Sequence Set: If the worker is directed on how the work is to be done, the TWC will view them as an employee.
  11. Oral or Written Reports: The belief by the TWC is that an independent contractor would not be required to submit a progress report in the middle of a project.
  12. Payment by the Hour, Week, or Month: This is similar to the IRS’s analysis of type of payment and, accordingly, should be viewed the same way. Generally speaking, hourly, or other pay made in regular intervals, would lead to a consideration of employment. There are numerous exceptions however including time and materials contracts and law firms.
  13. Payment of Business & Travel Expense: Similar to the IRS, the general belief is that employee’s expenses are covered where an independent contractor’s are not. This, of course, ignores the presence of time and materials contracts that provide for reimbursement of almost all of a contractor’s expenses.
  14. Furnishing Tools & Equipment: In this relatively simple analysis, the TWC will look to see who provided the worker with the tools they needed to complete the project. An independent contractor will likely maintain their own tools.
  15. Significant Investment: The TWC provides, very succinctly, “an Employee generally has little or no investment in the business. Instead, an Employee is economically dependent on the employer. True Independent Contractors usually have a substantial financial investment in their independent business.”
  16. Realize Profit or Loss: Similar to the IRS, this factor carries relatively heavy weight as an employee is generally compensated a fixed amount for work done and does not stand to either lose money or make money by working on a project. Where there is the possibility that a worker has invested money into materials and labor and may not see all of that money back on a project, the TWC will lean independent contractor.
  17. Working for More Than One Firm at a Time: Similar to number 8 above, the test will look to whom the independent contractor may work for at any given time.
  18. Making Service Available to the Public: In a continuance of numbers 8 and 17, the TWC will look to see if the worker is offering their services for sale elsewhere. Basically, are they advertising themselves as a service provider.
  19. Right to Discharge Without Liability: The idea here is that when an employee is terminated, that is the end of their dealings with the employer whereas when an independent contractor is terminated, there is likely some breach of contract present.
  20. Right to Quit Without Liability: Merely diving further into the rationale of 19, once the employee quits, they are done with, generally, no further questions. An independent contractor likely has a contract to honor.

It is important to note, and glaringly evident upon review of the above standards, that neither the IRS nor the TWC has established a test or specific review that creates a bright line, no questions asked, determination of employment status. All reviews are based on the facts and circumstances surrounding the engagement and, in most cases, careful attention will be given by the IRS and the TWC to make the right determination.

When do these questions arise and what happens next?

If a taxpayer is in a position where they realize that they have misclassified workers as independent contractors and want to correct their mistake, the IRS offers a Voluntary Classification Settlement Program (VCSP) wherein an eligible taxpayer may self-report their misclassification, make a promise to correct the classification going forward, be allowed to pay 10% of the amount that would have been due in employment taxes for those workers, and be granted amnesty for penalties and interest resulting from the misclassification in prior years.

To qualify for the VCSP, a taxpayer must:

  1. currently be treating their workers as independent contractors;
  2. have consistently treated the workers to be reclassified as independent contractors including having filed all required Forms 1099 for the workers to be reclassified under the VCSP for the previous three years (if applicable); and
  3. not currently be under employment tax or worker classification audit by the IRS or by a state government agency.

Other than the above voluntary admission, these analyses generally arise as the result of an audit. For any number of reasons, either the IRS or the TWC may open an investigation into a taxpayer to check for worker misclassification. Note that the IRS and the TWC do not specifically work together but they are able to communicate and have been known to do so. In the event of an audit, it is best to seek counsel immediately as there are numerous ways in which you may find yourself trapped by procedure. Basically, though, you will receive a notice of classification from either the IRS, the TWC, or both and be given the right to appeal. The appeal is an administrative process done predominantly through submission of arguments and evidence. If appeals determines that you have misclassified your workers, you may be left needing to file suit to escalate your matter to the US Tax Court for IRS disputes or the Texas courts for TWC disputes.

The process of defending yourself from an audit from either the IRS or TWC will likely be very costly so it would behoove all taxpayers hiring laborers to provide services to their business to take time to review the nature of their relationship and ensure that it meets with the above listed analyses.

Endnotes