Despite a "New" Simplified IRS Approach, Confusion Remains (Independent Contractors)

June 1, 1996 Advisory

Classifying workers as employees or independent contractors continues to bedevil businesses, both small and large. Recently, the U.S. Department of Labor announced a major investigation of a large computer company that laid off hundreds of workers and rehired many of them as independent contractors. Although many companies legitimately use independent contractors to save money, be more competitive and achieve greater flexibility in an ever changing market, a mistake in characterizing a worker as an independent contractor can be very expensive. Liability potentially includes not only damages for unpaid overtime under wage and hour laws, but also tax penalties for the employer's failure to make proper withholding for taxes and social security.

The Internal Revenue Service has abandoned its longstanding twenty factor checklist for determining independent contractor status, and instead has promulgated new guidelines in an attempt to simplify and clarify the traditional criteria. Under the new guidelines, I.R.S. agents are directed to review three broad areas:

  1. behavioral control;
  2. financial control; and
  3. the relationship of the parties.

The inquiry into behavioral control includes factors that indicate whether or not the company has the right to control the worker or direct how the worker performs his or her job. The financial control aspect of the inquiry examines whether the company controls the business aspects of the worker's activities. According to the I.R.S., the most significant issue under the rubric of financial control is whether or not the worker can realize a profit or incur a loss on the work. Finally, the I.R.S. agents are being asked to examine the relationship of the parties, such as whether or not there is a written contract, whether benefits are provided and how the relationship may be terminated.

The new guidelines are designed to help I.R.S. agents gain an understanding of how the company operates and how the worker fits into its operations before determining the worker's status. The guidelines are also a response to criticism from the business community that the old rules were too confusing and were often applied by government employees who seemed hostile to the entire independent contractor concept. The I.R.S. acknowledges this may have been the case and has begun an agent training program to address these concerns.

Despite the I.R.S.'s "new" approach, it is apparent that the fundamental inquiry remains the same - the kind and degree of control that the company exercises over the worker. The more control retained by the company over the work performed, the more likely the relationship with the worker will be viewed as one of employment rather than independent contractor.