CHOOSE IF YOU DARE: THE 20-FACTOR TEST AND FEDERAL AND STATE IMPLICATIONS OF MAKING THE WRONG DECISION December 5, 2012 Michal E. Yarborough, CPA Carruthers & Roth, P.A. 235 N. Edgeworth Street Post Office Box 540 Greensboro, North Carolina 27402 Phone: (336) 478-1187 Fax: (336) 478-1155 E-mail: mey@crlaw.com INTRODUCTION In a world of increased telecommuting and flexible work arrangements, the question of whether a worker is an employee or independent contractor becomes tricky. Despite this difficulty, an employer’s financial risk of misclassifying a worker can increase very quickly if one or more government entities, federal or state, determine that a worker is, in fact, an employee. This paper explores the appropriate factors 1 an employer should consider when determining whether to treat a worker as an employee or an independent contractor, as well as federal and state law implications of making an incorrect decision. I. The Twenty-Factor Test The primary test of whether an individual should be classified as an independent contractor or an employee is the extent of control exercised by the employer over the individual, the degree 1 Please note that no one factor is controlling as the courts utilize a balancing test composed of the various factors discussed herein. 1
of which is analyzed using the 20-Factor Test. 2 See Rev. Rul. 87-41. See also Reg. Sec. 31.3121(d)-1(c)(1). 3 The IRS provided the 20-Factor Test in Revenue Ruling (“Rev. Rul.”) 87- 41, in which it discusses Section 530 of the 1978 Revenue Act, which addresses taxpayer safe- harbors regarding tax treatment of workers. The IRS balances these factors in making its final determination. Note, however, that the weight of any one factor will change depending upon the facts and circumstances of the occupation and the working relationship between the individual and the employer. Also, the IRS applies the 20-Factor Test in light of the particular industry at issue and the facts and circumstances of each situation. Analysis of these factors is subjective, and the final test is the extent to which the employer controls the worker in the performance of their services for the employer using the factors specified under the 20-Factor Test. Some literature suggests that, of these factors, the IRS focuses on integration (the degree to which the worker has become integrated into the operating organization), continuity (the substantial nature, regularity and continuity of the worker’s work for the firm or person involved), the authority reserved by the person or firm to require compliance with its general policies and the degree to which the worker has been accorded the rights and privileges generally established for the firm’s employees (i.e., fringe benefits). See Rev. Rul. 72-203, infra. For example, an IRS Training Course states: Remember, however, that this Twenty Factor Test is an analytical tool and not the legal test used for determining worker status. The legal test is whether there is a right to direct and control the means and details of the work… The twenty common law factors listed in Rev. Rul. 87-41 are not the only ones that may be important. Every piece of information that helps determine the extent to which the business retains the right to control the worker is 2 Note that a court is not obliged to use the 20 Factor Test in determining whether an employer reasonably (though mistakenly) determined that a worker was an independent contractor under Section 530 of the 1978 Revenue Act, P.L. 95-600. Queensgate Dental Family Practice, Inc. v. U.S., 68 AFTR 2d 91-5679 (1991). However, such courts will consider the control of the employer over the worker – analysis directly in line with the 20-Factor Test. 3 This regulation specifically mentions certain factors used to determine whether an individual is controlled as an employee, including the employer’s right to control the details and means by which the worker provides services, the employer’s right to discharge the employee, the furnishing of tools and a place to work to the employee. 2
important. In addition, the relative importance and weight of the twenty common law factors can vary significantly. 3320-102, TPDS 842381 (10/30/96) Moreover, Internal Revenue Manual Section 4.23.5.6.1(2) (11-03-2009) states: [T]hese are not the only factors that may be important, and in certain cases some of the traditional twenty factors may be disregarded as unimportant. Every piece of information in a case that helps the extent to which the firm does or does not retain the right to control the worker is important. Rather than listing items of evidence under the twenty factors, items of evidence are grouped into three main categories: 1. Behavioral control; 2. Financial control; and 3. Relationship of the parties. In the IRS Training Course, these categories are described as follows: 1. Behavioral Control: Facts which illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is engaged a. Instructions b. Training 2. Financial Control: Facts which illustrate whether there is a right to direct or control how the business aspects of the worker’s activities are conducted: a. Significant Investment by the Worker b. Unreimbursed Expenses c. Services Available to the Relevant Market: Can the worker advertise and provide his or her services to the relevant market place? d. Compensation: Is the worker compensated with a salary/hourly wage, a flat fee or a commission? e. Profit v. Loss: Does the worker have the opportunity for profit or loss? 3. Relationship of the Parties: Facts which illustrate how the parties perceive their relationship: a. Intent of Parties/Written Contracts b. Employee Benefits c. Discharge/Termination—Can either the business or the worker terminate the relationship at will and without penalty? 3
d. Regular Business Activity—Is the worker’s service part of the regular business of the employer? Contrast a CPA’s relationship with his or her client versus his or her relationship with the CPA firm. II. Application of the 20-Factor Test by the Courts and the IRS The categories discussed above are captured within an analysis of the Twenty Factors. The following list includes the Twenty Factors with brief descriptions provided in Revenue Ruling 87-41, as well as brief descriptions of selected tax cases that consider the relevant factor. Note that each of these cases involve many of the 20 Factors, and courts or the IRS balanced these factors to reach a final determination in each case. A. The Factors 1. Instructions. A worker who is required to comply with the other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions. See Rev. Rul. 68-598; Rev. Rul. 66-381. 2. Training. Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner. Rev. Rul. 70-630. 3. Integration. Integration of the worker’s services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends to an appreciable degree upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business. See United States v. Silk, 331 U.S. 704 (1947). 4
4. Services Rendered Personally. If the services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results. Rev. Rul. 55-695. 5. Hiring, Supervising, and Paying Assistants. If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status. Cf. Rev. Rul. 63-115 with Rev. Rul. 55-593. 6. Continuing Relationship. A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals. United State v. Silk, 331 U.S. 704 (1947). See also Rev. Rul. 72-203 (where associates were employees where they performed substantial services on a regular and continuous basis.) 7. Set Hours of Work. The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control. Rev. Rul. 73-591. 8. Full Time Required. If the worker must devote substantially full time to a business, the business has control over the amount of time the worker spends working and impliedly restricts the worker from doing other gainful work. In contrast, an independent contractor is free to work when and for whom he or she chooses. Rev. Rul. 56-694. 9. Doing Work on Employer’s Premises. If the work is performed on the premises of the person or persons for whom the services are performed that factor suggests control over the 5
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