Employee Classification

In general, employers, including nonprofit tax-exempt organizations, often prefer to classify a worker as an independent contractor rather than an employee. Many states are redefining the classification rules and making it more difficult to classify an individual as an independent contractor. The classification of an individual as an employee or an independent contractor affects the employer’s obligation to withhold taxes, secure workers compensation, pay federal and state unemployment taxes, and pay disability benefits. It also affects the employer’s liability for injury or damage to the individual and injury or damage caused by the individual. Independent contractors are generally responsible for their actions. In contrast, the behavior of an employee is subject to the control of the employer.

Note: For purposes of this discussion, the term “employer” refers to the hiring party without implying that the hired party is an employee or an independent contractor.

The Treasury Regulations

Reg. 31.3306(i)-1 provides that the nature of the employment relationship is determined by the employer’s right, whether or not exercised, to control the performance of the worker’s methods and results.

  • Employees are required to follow the employer’s instructions regarding what must be done and how to do it.
  • Independent contractors are required to follow the employer’s instructions regarding what must be done but not the methods used to do it.

Regardless of the written documentation or contractual language used, the determination is made based on the substance of the relationship, not its form.

While the Treasury Regulations list a few factors to consider, the Internal Revenue Service has issued numerous rulings based on specific fact patterns.

IRS Revenue Rulings

  1. Rev. Rul. 57-119: Officials are EmployeesIn 1957, the IRS ruled that game officials were employees of an athletic association composed of colleges and universities since the association selected, trained, and supervised the individuals and controlled their behavior.
  2. Rev. Rul. 67-119: Officials are not EmployeesIn 1967, the IRS ruled that game officials paid on a per-game basis by the respective schools for which they perform their services are not employees of the athletic association composed of colleges and universities. The ruling did not address whether the officials are employees of the school or team that hires them.
  3. Rev. Rul. 87-41: The IRS’s 20 Common Law FactorsFollowing major tax reform in 1986, the IRS issued Rev. Rul. 87-41 to identify and clarify the various factors that determine whether the worker should be classified as an employee or an independent contractor. The relative weight of the various factors depends on the facts and circumstances. In general, factors answered “yes” indicate an employee relationship, and factors answered “no” indicate an independent contractor relationship.
  1. Instructions: Does the employer have the right to require the worker to comply with instructions regarding when, where, and how the work is to be performed? (Rev. Rul. 68-598)
  2. Training: Does the employer require that one of its trained workers provide training to new workers so that the services are performed in a prescribed manner? Are new workers required to correspond with or attend meetings with experienced workers? (Rev. Rul. 70-630)
  3. Integration: Are the workers’ activities a critical component of the success or continuation of the employer’s business? For example, an electrician hired by an electrical company is likely an employee, while an electrician hired by an accounting firm is likely an independent contractor. (United States v. Silk)
  4. Services Rendered Personally: Does the worker perform, on a continuing basis, personal services under the direction and control (or the right to exercise direction and control) of the employer? (Rev. Rul. 55-695)
  5. Providing Assistants: Does the worker have assistants that are hired, supervised, or paid by the employer? (Rev. Rul. 63-115)
  6. Term of Relationship: Is the engagement for an indefinite period, as opposed to a specific time period or project? (United States v. Silk)
  7. Set Hours of Work: Is the worker required to perform the job during the employer’s regular business hours? Note that with recent developments in flexible work arrangements, this fact is largely obsolete. (Rev. Rul. 73-591)
  8. Full-Time Required: Is the worker devoting substantially full-time hours to the employer, as opposed to providing services to more than one business at the same time or having other gainful work? Note that this is no longer considered a significant factor since many employees work part-time, and certain independent contracts require exclusive effort. (Rev. Rul. 56-694)
  9. Location: Is the worker required to be present on the employer’s premises, travel a designated route, canvass a specified territory within a certain time, or work at a designated location? Note that with recent developments in teleworking, the absence of this factor no longer indicates independent contractor status. (Rev. Rul. 56-660 and Rev. Rul. 56-694)
  10. Order or Sequence Set: Is the worker required to follow detailed instructions, such as a specific sequence of tasks or services, as opposed to following independent patterns to accomplish the job? (Rev. Rul. 56-694)
  11. Oral or Written Reports: Is there an evaluation system that measures the worker’s compliance with performance standards, as opposed to evaluating the finished result? Note that this factor is largely obsolete. (Rev. Rul. 70-309 and Rev. Rul. 68-248)
  12. Payment by Hour, Week, Month: Is the worker guaranteed payment for labor based on the amount of time spent, as opposed to a fixed fee? Note that payment of commissions is not indicative of either status. Also note that professional services provided by the hour, such as legal and external auditing services, are not evidence of employee status. (Rev. Rul. 74-389)
  13. Payment of Business or Traveling Expenses: Does the employer reimburse the worker’s business or traveling expenses, indicating that cost control and risk of loss lie with the employer? Although independent contractors may have reimbursed expenses, employees generally will not have unreimbursed expenses. (Rev. Rul. 55-144)
  14. Furnishing of Tools and Materials: Does the employer furnish significant tools, materials, and other equipment, as opposed to the worker making a significant investment in such items? (Rev. Rul. 71-524)
  15. Significant Investment: Is the employer the investor in the facilities used by the worker, as opposed to the worker being independent of facilities provided by the employer? Note that some services, such as in the creative fields, may not require a significant investment in equipment, space, or similar items. (Rev. Rul. 71-524)
  16. Realization of Profit or Loss: Does the ability to realize a profit or loss, control the business aspects of the services, and make decisions which affect the bottom line rest solely with the employer? For example, do decisions about inventory, investments, capital acquisitions, and purchasing vs. leasing equipment have an impact on the finances of the employer as opposed to the worker? Note that the ability to work overtime is not the same as the ability to realize a profit. Also, note that the risk of not being paid by the employer is common to both independent contractors and employees. (Rev. Rul. 70-309)
  17. Working for More than One Firm at a Time: Is the worker prevented from providing more than de minimis services for unrelated persons or employers at the same time? Independent contractors are generally free to seek out additional business opportunities, while employees are often restricted in their ability to work for multiple employers simultaneously, particularly competitors. (Rev. Rul. 70-572)
  18. Making Services Available to General Public: Is it unnecessary for the worker to attract additional customers or to make the service offerings visible to the public through a physical location, website, and advertising? Independent contractors typically do such things, while employees rarely do. (Rev. Rul. 56-660)
  19. Right to Fire: Can the employer discharge the worker without incurring any liability? Must the employer pay the worker for substandard work? Generally, an independent contractor cannot be fired if the contract specifications are being met, but the employer may have the ability to refuse payment for unsatisfactory performance. Note that this factor is of decreased importance as most contracts now include specific remedies for nonperformance, and employees can be sued for failure to perform. (Rev. Rul. 75-41)
  20. Right to Quit: Can the worker quit at any time without incurring any liability? While employees can simply ‘walk off the job,’ an independent contractor would be in breach of contract for doing so. (Rev. Rul. 70-309)

The IRS’s Internal Revenue Manual Standards

  1. Behavioral Control:
    • a. Does the employer have the ability to control the details and the methods used by the worker to complete the task?
    • b. Are there detailed instructions regarding when and where the work is to be performed, what tools and supplies to buy or use, and what order or pattern to follow? Note that detailed instructions imposed by an outside governmental agency or governing authority are not relevant to determining worker classification.
    • c. Is there ongoing training to ensure the employer’s methods are followed?
    • d. What are the consequences for noncompliance?
    • e. Must the worker obtain approval or permission before taking specific actions?
    • f. Is the worker evaluated on the results or on the conformance to standards during the process?
    • g. Is the worker required to wear a uniform or display the employer’s identifying trademarks? Requiring the worker to wear an identifying uniform may be an indication of status as an employee unless the nature of the occupation requires, for safety and security purposes, that the worker be identified with the employer’s business.
    • h. With recent developments in flexible work arrangements, employers are exercising less control over the location and the hours of certain workers. Such arrangements are not necessarily indicative of status as an independent contractor.
  2. Financial control:
    • a. Who has made a significant, substantial investment in the activity? Who pays for equipment, office space, internet access, etc.?
    • b. Who assumes responsibility for cost control? Are all expenses incurred by the worker reimbursed by the employer? Who pays for travel expenses?
    • c. Is the worker free to seek out additional work opportunities? Do they advertise, maintain a website, depend on word of mouth referrals, and offer simultaneous services to multiple employers? A non-compete agreement is an indication of status as an employee.
    • d. Is payment determined by time or by a fixed fee? If paid by commission, is there an additional guaranteed salary or wage? For certain professional services, such as legal and external auditing, it is common for independent contractors to be compensated by the hour.
    • e. Must the worker obtain approval or permission before taking specific actions?
    • e. Who controls the bottom line? Does the worker realize the same profit regardless of the financial results? Who makes decisions regarding inventory, investments, capital acquisitions, and purchasing vs. leasing equipment? The ability to experience one’s own profit or loss from the activity is one of the most relevant factors in identifying independent contractor status. Note that the ability to earn more (or less) by increasing (or decreasing) one’s hours is indicative of status as an employee.
  3. Relationship of the parties:
    • a. Is there a written agreement demonstrating the parties’ intention of establishing an independent contractor relationship? Was the intention put in writing at the beginning of the relationship, or after the fact? While not conclusive, the intent of the parties can be useful when other factors are inconclusive. (Illinois Tri-Seal Products, Inc.)
    • b. Does the worker receive paid vacation, paid sick leave, health and welfare benefits, pension, or other benefits? Certain benefits, such as employer contributions to a qualified retirement plan, can only be provided to employees.
    • c. Can the worker be discharged for any reason without incurring employer liability, and is the employer generally required to pay the worker even for substandard work? Generally, an independent contractor cannot be fired as long as the contract specifications are being met, but the employer may have the ability to refuse payment for unsatisfactory performance. Note that this factor is of decreased importance as most contracts now include specific remedies for nonperformance, and employees can be successfully sued for failure to perform.
    • d. How permanent is the relationship? Does the contract cover a specified time period, or is it open-ended and indefinite? Note that some employees may have contracts for a specific time, and some independent contractors may have indefinite time periods, so this factor must be weighed carefully. (Darryl L. Jones v. Commissioner, Mieczyslaw Kurek v. Commissioner)
    • e. Are the services provided by the worker a key aspect to the ongoing business of the employer? For example, an electrician hired by an electrical company is likely an employee, while an electrician hired by an accounting firm is likely an independent contractor.
    • f. Is the worker providing services through a separate corporation?

Statutory Employees

A worker may appear to have status as an independent contractor yet be required by law to be classified as an employee. Such workers may be subject to some, but not all, of the payroll tax statutes. For example, a statutory employee may be subject to withholding for Social Security and Medicare taxes but not for federal income tax. Specific occupations include corporate officers, agent or commission drivers, full-time traveling salespersons, full-time life insurance agents, and homeworkers.

Professional Services

Certain occupations require high levels of independence and skill (lawyers, outside accountants, architects, etc.). The lack of behavioral control is not the determining factor in the classification of such workers since no client would rightly attempt to control the methods used by such professionals. In addition, such highly trained and educated professionals may require little, if any, training from the employer.

Instead, the determining factors are primarily based on financial control. For example, an attorney who engages with other clients and bears all the risk of financial gain or loss is likely an independent contractor. In contrast, an attorney (such as a member of management serving as general counsel or chief legal officer) who provides services exclusively to a single employer and whose compensation is not dependent on any risk of financial loss or gain is likely an employee.

Technical Services

Certain workers may be classified as independent contractors even though they appear to meet the description of employees. Technical service specialists, such as a designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work (IRS Notice 87-18), may go into business for themselves but utilize a broker or placement agency to find work. The broker identifies customers and then engages with the specialist to provide services to that customer. Under such circumstances, both the worker’s relationship with the client and with the broker or agent must be analyzed.

Section 530 Relief

Since 1978, taxpayers have had a relief provision available that prevents the IRS from reclassifying a worker as an employee solely for payroll tax purposes if the business has a reasonable basis for consistently treating the worker as an independent contractor. The relief is available even if the worker is an employee under the ordinary control rules described above. If applicable, the employer may continue to classify the worker as an independent contractor and the IRS cannot collect payroll taxes from the employer.

Under the relief provision, an employer can treat a worker as an independent contractor if the employer has:

  1. historically treated the worker’s occupation ((and every other worker performing the same or a similar job)) as an independent contractor,
  2. complied with certain information return requirements, and
  3. demonstrated a reasonable basis for treating the worker as an independent contractor.

Effectively, an organization cannot change a worker’s classification from employee to independent contractor and then seek Section 530 relief. Form 1099 must have been filed timely and consistently for the individual and all similarly situated individuals. “Reasonable basis” includes the long-standing recognized practice of a significant segment of the industry in which the individual worked. “Long-standing” is not defined, and “significant segment” is understood to mean that in no case will the employer be required to show that the practice is followed by more than 25% of the industry. “Reasonable basis” also includes written advice from a lawyer or accountant in possession of all of the relevant facts.

An employer can file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to request a determination of worker classification.

Court Decisions

In Collegiate Basketball Officials Association v. NLRB, the US Court of Appeals for the 3rd Circuit held that the NLRB’s classification of college basketball officials as independent contractors was supported by substantial evidence. Because the Court was relying on the NLRB’s expertise, this case has no value as precedent. However, the Court did conclude that the fact that the officials were required to wear a designated uniform, appear for work at a certain time and place, and abide by a strict set of rules did not make them employees, even though these are factors that often indicate an employee classification.

In Zajaczkowski v. Connecticut State Soccer Association, the Connecticut Superior Court noted that the referee attended training sessions through an independent referee organization separate and distinct from the employer. The referee was paid by the home team on a game by game basis and was not paid a salary. The employer could assign the referee to a match, but the referee had the option to decline any assignment. The referee had sole control and discretion over the enforcement of the rules, and the Court concluded that the referee was an independent contractor.

In Gale v. Greater Washington Softball Umpires Association, the Maryland Court of Special Appeals determined that a softball umpire was an independent contractor even though the umpires association trained him and required him to officiate a minimum number of games. The Court determined that the umpire had control over the way he called the game, making him an independent contractor.

In Farrar v. D. W. Daniel High School, the Court of Appeals of South Carolina ruled that a high school referee was not an employee because neither the league nor the referees’ association controlled how he called the game. The Court noted that after he was engaged to officiate the game, the employer could not reduce or increase his compensation according to the manner in which he performed or the time he took to complete the work, nor could the employer terminate him during the game. Also, the referee supplied his own uniform, shoes, flags, stopwatch, and other officiating equipment.

In O’Neil v. Blasdell High School, the Appellate Division of the New York Supreme Court ruled that the employer exercised no control over the details of the football official’s work, that no equipment was furnished, and that the employer had no right to discharge the official. The Court concluded that the worker was an independent contractor.

In Lynch v. Workmen’s Compensation Appeal Board (Connellsville Area School District), the Pennsylvania Commonwealth Court noted that the official was paid by the job rather than by the time spent doing the job, the school did not provide the relevant training to perform the job, he provided similar services to other organizations during the same season, he supplied his own clothing and whistle, and the employer had no right to dismiss him. The employer could not order the official to change a ruling made on the field, the official’s work was not intended to benefit the employer, and the employer could not direct how the work was to be accomplished. In ruling that the individual was an independent contractor, the Court rejected the argument that the rules and regulations that the official was engaged to enforce did not constitute the employer directing and controlling how the officiating must be conducted. It was up to the official’s judgement to interpret, apply, and enforce the rules, and the employer exercised no control over the official’s behavior. The official was paid by the game, regardless of how long it took to complete.

In Ford v. Bonner County School District, the Idaho Supreme Court classified an injured sports official as an employee for purposes of workers’ compensation. Subsequently, the Idaho legislature effectively reversed the decision by making amateur sports officials independent contractors for purposes of workers’ compensation.

State Law

Several states have passed legislation specifying that specific workers are employees for purposes of workers’ compensation. For example, the so-called “gig” economy includes freelance artists, couriers, ride-hailing services, and other short-term contracts. These workers are not paid a regular wage. Instead, they are compensated for the small piece of work performed. California recently passed legislation that would define such workers as employees unless the employer can prove that:

  1. The worker is “free from the control and direction” of the employer while the work is being performed,
  2. The work falls “outside the hiring entity’s usual course of business,” and
  3. The worker has a business outside the gig.

The reason behind the forced classification is that the gig economy provides limited entrepreneurship, the employer tightly controls the hours and manner of work, the employer sets the price the customer will pay, and the worker can be fired.

Conclusion

Tax-exempt organizations should consider the following when determining employee classification:

  • Financial Control Test – Who bears the financial risk? Who controls costs? Who pays for space, equipment, travel, and overhead? Can the worker seek out other contemporaneous work opportunities in the same field? Is the compensation arrangement determined by time (day, week, season) or by fixed fee?
  • Behavioral Control Test – Do the workers have immediate supervisors? Are they expected to wear the employer’s identifying trademarks on their clothing and attire? Even if given latitude to determine specific methods, do the supervisors retain the absolute right to exercise control over the individual’s performance?
  • Relationship of the Parties Test – Do the workers receive benefits? Can they be terminated without cause? Do they provide services that are an ongoing aspect of the employer’s activities? Is the contract open-ended or for a specific period?

For more information, please reach out to us for a free initial consultation.