Just How Do You Define an "Employee"?

By Donald H. Grim

December 2011

Many businesses prefer to hire independent contractors to simplify their payroll and avoid expenses associated with employee withholdings. They should be aware that how their business categorizes workers in tax filings is not determinative for the taxing authorities. The Internal Revenue Service (IRS) and Oregon Department of Revenue (ODR) each have their own set of criteria for distinguishing employees from subcontractors. Both agencies look to their own guidelines -- not your designation -- to determine whether a worker is an employee or subcontractor.

Knowing the difference between an employee and a subcontractor – in the eyes of the taxing authorities – can save you an unpleasant and very expensive visit by the IRS or ODR. If your business is audited and has wrongly classified an employee as a subcontractor, the taxing authority will reclassify the worker and assess the taxes you should have withheld and paid. In addition, you likely will be assessed substantial penalties and interest. In some cases, the amount assessed can be overwhelming. If your business cannot pay the tax, you may be personally assessed the withholding portion as a civil penalty.

The IRS has published a set of twenty criteria to help distinguish employees from independent contractors. If you are considering hiring someone as an independent contractor, you should be familiar with these guidelines and the ODR’s guidelines (this article only addresses the IRS’s criteria). The primary issue is the extent to which you have control over the worker: the more control you have over the worker, the more likely the worker is to be an employee. I have condensed the 20-point IRS guidelines as follows:

• Instructions. A worker who is required to comply with instructions about when, where, and how he or she is to work is ordinarily an employee. Even if your business doesn't give instructions, the worker is considered an employee if the business has the right to require compliance with instructions.
• Training. If you provide training to the worker, this indicates an employee-employer relationship
• Integration. If the worker's activities are integrated into the flow of work performed by employees at the business, it is likely the worker is an employee
• Services rendered personally. If the worker must perform the required services personally, as opposed to having the ability to substitute in other people to perform the service, it is more likely that the worker is an employee. (This is exclusive of people with specialized talents such as performing artists.)
• Hiring, supervising, and paying assistants. Independent contractor status is more likely if the worker hires, supervises, and pays his or her own assistants, especially if the worker is responsible only for the results obtained and not the methods employed.
• Continuing relationship. A continuing (ongoing) relationship is more likely to indicate an employer-employee relationship.
• Set hours of work. If your business sets the worker's days and hours of work, this indicates an employer-employee relationship.
• Full time required. If the worker is required to work full-time or nearly full-time, this likely indicates an employer-employee relationship.
• Performing work on employer's premises. An employee-employer relationship is more likely if the worker must perform the work on the premises, especially if the work is of a type that could be performed elsewhere.
• Order or sequence set. If the worker must follow a set pattern or sequence as set by your business, an employee-employer relationship is more likely.
• Oral or written reports. If the worker must submit regular or written reports to you, an employee-employer relationship is more likely.
• Payment by hour, week, month. Hourly, weekly, or monthly payments make an employee-employer relationship more likely.
• Payment of business and/or travel expenses. If the worker's travel or business expenses are paid by your business, an employee-employer relationship is more likely.
• Furnishing tools and materials. If you provide the worker's tools and materials, an employee-employer relationship is more likely.
• Significant investment. If the worker invests in his or her own facilities (such as office or shop space), it is more likely that the worker is an independent contractor.
• Realization of profit or loss. If the worker can realize a profit or loss as a result of the services provided, it is more likely that the worker is an independent contractor.
• Working for more than one firm at a time. If the worker provides services for multiple and unrelated persons or firms, it is more likely that the worker is an independent contractor.
• Making service available to the general public. If the worker makes his or her services available to the general public, it is more likely that the worker is an independent contractor.
• Right to discharge. An employer exercises control by holding the power to terminate an employee. On the other hand, an independent contractor can generally not be fired so long as the results meet the contract's specifications.
• Right to terminate. An employee at will has the right to terminate his or her employment without incurring liability. An independent contractor is subject to the terms of a contractual arrangement and may be subject to liability for leaving before the completion of a project.

If you hire someone as an independent contractor and are not certain they qualify as such, you might consider professional advice. Your CPA or accountant should be able to provide direction. The alternative -- to wait and see what the IRS or ODR thinks of your business arrangement -- may not have a happy ending.

Donald H. Grim is an attorney at Greene & Markley. His practice focuses on tax determination, tax collection controversies, bankruptcy and estate planning. He can be reached at donald.grim@greenemarkley.com or (503) 295-2668.

This article appeared in the December 2011 issue of the Coast River Business Journal.