Securing and Paying for Consultant and Independent Contractor Services

Section I

"Employee or Independent Contractor?"

Guidelines for Determining Employment Relationships
by R.C. Chip Goldsberry

The ability to correctly identify people engaged to provide goods or services as either employees or independent contractors can lower an institution's tax liability and increase its chances of withstanding an Internal Revenue Service audit.

Recently IRS auditors have given high priority to correct classification of employment relationships and the tax implications of decisions made. The IRS has announced that its emphasis on employment relationships and tax reporting will continue in the foreseeable future.

Employers are legally required to pay FICA, FUTA, and withheld income tax on the wages of workers classified as employees. If the worker is legitimately characterized as an independent contractor, the employer is not responsible for employment-related taxes.

Definitions of the terms "employee" and "independent contractor" may provide a helpful context within which to make the correct employment decision. An employee is an individual who performs services that are subject to the will and control of an employer-both what must be done and how it must be done. The employer can allow the employee considerable discretion and freedom of action, so long as the employer has the legal right to control both the method and the result of the services.

An independent contractor is an individual over whom the employer has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

Determining the correct employment relationship is often an ambiguous task. The IRS has provided a list of 20 common law factors to assist in determining if the service provider is an employee or an independent contractor.

These factors, which appear in IRS Revenue Ruling 87-41, are intended as guidelines rather than strict rules. The closeness of most of a situation's facts to one relationship or the other will often determine what the appropriate classification should be. If the proper relationship is unclear after analyzing these factors, the employer-employee relationship should be established.

20 RULE TEST
1. An employee is required to comply with instructions about when, where, and how to work. The employer's right to instruct, not the exercise of that right, is the key. Instruction may be oral or in written procedures or manuals.

An independent contractor is hired to provide goods or services and is not instructed in great detail about how to provide the goods or services.

2. An employee is usually trained by one of the institution's experienced employees. Training indicates that the employer wants the services performed in a certain manner.

An independent contractor ordinarily uses his or her own methods, is hired for his or her expertise, and receives no training from the institution that purchases services.

3. An employee's services are usually integrated into business operations, generally showing that direction and control are being exercised. Integration of services into the business operation occurs when the success or continuation of a business depends to an appreciable degree on the performance of services that are difficult to separate from the business operation.

An independent contractor's services can usually stand alone and are not integrated into business operations.

4. An employee is hired to render services personally. If the employer is interested in who does the job as well as in getting the job done, it indicates that the employer is concerned about the methods used as well as the results of services performed.

An independent contractor is hired to provide a service and often the employer does not care who performs that job.

5. An employee has little control over the hiring, supervising, and payment of assistants. Such action by an employer generally shows control over people on the job with whom assistants work.

An independent contractor will hire, supervise, and pay other workers under a contract in which he or she agrees to provide materials labor and is responsible for the attainment of a given result.

6. An employee normally has a continuing relationship with the person for whom services are performed. Services may be continuing even though they are performed at irregular intervals, on a part-time basis, seasonally, or over a short term.

An independent contractor has a defined relationship that typically ends when the services are completed.

7. An employee has set hours of work established by the employer, indicative of control. Such a condition bars the worker from allocating time to other work, which is a right of an independent contractor.

An independent contractor tends to establish time use as a matter of right.

8. An employee usually devotes full time to the business of the employer. Full time does not necessarily mean an eight-hour day or five-day week. Its meaning varies depending on the intent of the parties.

An independent contractor is free to work when, for whom, and for as many employers as desired.

9. An employee typically does his or her work on the employer's premises which implies control, especially if the work could be performed elsewhere. Someone who works in the employer's place of business is at least physically within the employer's direction and supervision. However, performance of work off-site does not, of itself, mean that no right to control exists.

An independent contractor usually does work that can be completed on or off the employer's premises.

10. An employee often must perform services in a prescribed sequence, which shows a level of employer control. Here, too, the right to set the sequence, not the exercise of that right, is the key.

An independent contractor normally is free to perform services in any manner that produces desired results.

11. An employee submits or provides regular written or oral reports that indicate employer control.

An independent contractor submits reports as specified by the contract and may provide them in the broadest of terms and with less frequency than an employee would.

12. An employee is usually paid for work by the hour, week, or month. The guarantee of a minimum
salary or the granting of a drawing account at stated intervals with no requirement for repayment of the excess over earnings tends to indicate the existence of an employer-employee relationship.

An independent contractor is customarily paid by the job in a lump sum or on a commission basis.

13. An employee is reimbursed or paid by the employer for business and traveling expenses, a factor that indicates control over the worker.

An independent contractor is paid on a job basis and normally has to assume all expenses except those specified by contract.

14. An employee usually is furnished by the employer with any tools and materials needed, which is indicative of employer control over the worker. In some jobs employees customarily use their own hand tools.

An independent contractor supplies the tools and equipment.

15. An employee normally does not have a significant investment in the facilities used in the job.

An independent contractor often has a significant investment in facilities used in performing services. Facilities generally include equipment or premises necessary for the work, but not such items as tools, instruments, and clothing that are provided by employees as a common practice in their trade.

16. An employee usually does not realize a profit or suffer a loss as a result of the service provided.

An independent contractor is in a position to realize a profit or suffer a loss as a result of services provided.

17. An employee tends to work exclusively for one employer.

An independent contractor normally works for more than one employer at the same time.

18. An employee usually does not make services available to the general public.

An independent contractor makes services available to the general public. "Making services available" may include hanging out a shingle, holding a business license, and having advertising and telephone directory listings.

19. An employee is subject to discharge, showing that control is exercised. Limitation of the right to discharge under a collective bargaining agreement does not detract from the existence of an employer-employee relationship.

An independent contractor cannot be fired so long as results produced measure up to contract specifications.

20. An employee has the right to end the employment relationship at any time without incurring liability.

An independent contractor usually agrees to complete a specific job and is responsible for its satisfactory completion or is legally obligated to make good for failure to complete the job.

If administrators are still not sure whether a person is an employee or an independent contractor, they may file a Form SS-8 (Information for Use in Determining Whether a Worker Is an Employee for Federal Employment Tax Withholding) with the IRS to request an official determination. The Form SS-8 is available from local IRS offices.

SAFE HARBOR FOR INDEPENDENT CONTRACTORS

Until Congress enacts legislation on the classification of workers as independent contractors or employees, an employer can continue treating workers as independent contractors without incurring income tax withholding if:

• .a "reasonable basis" exists for not classifying the individual as an employee;
• the employer did not or does not treat a similar individual as an employee; and
• the employer files all tax returns required to be filed (including information returns) on the basis that an individual is not an employee.

An employer who meets the reasonable basis test can exclude an individual from employee status, if the employer reasonably relies on one of the following types of authority:

• judicial precedent, published rulings, or a technical advice memorandum ruling or a letter ruling issued to the employer;
• a past IRS audit of the employer in which the IRS did not assess employment tax deficiencies for amounts paid- to individuals holding positions substantially similar to a job held by an individual;
• a long-standing recognized practice of a significant segment of the industry in which an individual
  is engaged.

These three tests are not the exclusive means of satisfying the reasonable basis requirement. An employer may also meet the reasonable basis requirement by general evidence that the individual functions as an independent contractor rather than as an employee.

The safe harbor rules exclude technical personnel-such as engineers, computer programmers, systems analysts, or other similarly skilled workers-who are involved in three-party situations in which the specialist provides services for a client of a technical services firm pursuant to an arrangement between the firm and its client. These technical personnel, even if they are retained by a firm for the purpose of providing services to its clients, are treated as employees or independent contractors under the common law definitions discussed above.

CONCLUSION

Business officers need to assess if appropriate institutional mechanisms are in place that ensure correct employment relationship decisions are made. The assessment should begin with an examination of the current process for engaging independent contractors. A "review point" should be put in place that will test each situation for the proper employment relationship. Application of the 20 Rule Test can be a basic part of that review process. Procedures should be as nonbureaucratic as possible, yet complete enough to protect the institution in the event of an IRS audit. Some colleges and universities have placed their review point in the purchasing department, and others have chosen the human resources, accounting, or payroll areas.

Business methods are changing, and business officers must change with them.

Additional assistance may be obtained by reviewing IRS Code Section 3401. IRS Publication 539, Employment Taxes, is available from the IRS by calling 800-829-FORM. Most payroll services also have information.

R.C. Chip Goldsberry is assistant director of personnel services for compensation and information systems at Purdue University. He is a member of the NACUBO Benefits and Personnel Committee.