Accuchex Blog

3 Rules For Employee Classification

Posted by Tristan Ruhland on Jul 28, 2016 9:30:00 AM

Employee classification has become increasingly critical for employers and incorrectly classifying employees as independent contractors can be costly.


An article from recently noted, "This fundamental worker status issue has become one of the most consequential legal determinations around. If you’re in business and guess wrong, the liability for past years can be crushing."

And as recently as 2013 the IRS Inspector General issued a report saying that employers were still getting it wrong.

Classifying Your Employees Correctly is Critical

Mis-classifying employees can result in significant liability. And it is more common than one might think.

According to a article from HRCalifornia, "If your company controls the details and the worker does not have meaningful discretion in how he/she completes the work, it has generally been the rule that the worker will be found to be an employee and not an independent contractor."

In addition, state governments and the IRS are concerned about the loss of tax revenue when this occurs.

“This problem adversely affects employees because the employer’s share of taxes is not paid and the employee’s share is not withheld,” said J. Russell George, Treasury Inspector General for Tax Administration.

“If left unchecked, the problem will continue to deprive the Federal Government, and the American people, of millions of dollars in lost revenue every year,” he added.  

Do You Really Have Independent Contractors?

The truth for many businesses is that making use of independent contractors can be more efficient and cost-effective than relying solely on salaried employees.

Classifying a service provider as an independent contractor frees a business from several obligations such as tracking hours, paying required tax withholdings for wages, overtime, statutory benefits such as worker’s compensation coverage, unemployment benefits, health benefit plans and pension plans.

In addition, it limits liability for the errors and wrongs committed by the independent contractor.

Under California Labor Code Section 3353:

an “independent contractor” is defined as: Any person who renders service for a specified recompense for a specified result, under the control of his principle as to the result of his work only and not as to the means by which such result is accomplished.

In addition, the IRS has a checklist of 20 factors, which are based on the common law as developed in past court cases and administrative hearings. These factors, found at 4600 IRS manual, Exhibit 4640-1.

Establishing Your Employee Classification

Remember that these factors are only a guide for determining whether or not a worker is an employee, and the IRS recognizes that the degree of importance of each factor varies depending upon the occupation and the actual context in which the services are performed.

As an employer, you are expected to exercise sound judgment in your classification of workers. To help in making that call you can use the following tactics to help minimize a potential mis-classification:

  • Ensure that the business has a written agreement (an independent contractor agreement) with its independent contractors and that the independent contractor agreement describes the scope of the work to be performed, the compensation paid, the timing of the work and clearly define the independent contractor’s tax obligations;
  • Ensure that the independent contractor has liability insurance, particularly if that contractor is a professional.
  • Ensure that the independent contractor who is a professional has his or her pertinent license and that such license is current;
  • Ensure that the independent contractor has a current business license from the city/county in which he or she is operating;
  • Do not set independent contractor’s work hours;
  • Do not provide the independent contractor with tools, equipment, software or supplies with which to perform his or her work;
  • Do not provide the independent contractor any benefits, which the business provides to its employees.
  • Do not retain or terminate or attempt to retain or terminate assistants or employees for or of the independent contractor.
  • Ensure that the independent contractor submits invoices for his or her work.

Three Rules for Proper Employee Classification

Court cases have established three broad categories of factors for determining employee classification:

1. Behavioral control

Do you, as the employer, have a right to direct and control how the worker does the task that you hired them for? Behavioral control factors include the extent of:

  • Instructions you or your staff gives the worker. Normally, an employee is required to follow instructions regarding how, where, and when, he or she works. (Note that even if there are no explicit instructions provided, it can be deemed that sufficient behavioral control may exist you have the right to control how the worker's results are achieved.)
  • Any training your company provides the worker. While independent contractors normally implement their own methods, employees are often trained to perform their job by the employer.

2. Financial control

Does your business have a right to control the business aspects of the worker’s job such as:

  • The extent of un-reimbursed business expenses incurred. Independent contractors are likely to have un-reimbursed expenses whereas employees do not. Especially important are the fixed, ongoing costs that can be incurred regardless of whether or not the work is being performed.
  • The extent to which a profit can be realized or a loss incurred by the worker. An independent contractor, unlike most employees, can make a profit or loss.
  • The extent to which the worker has an investment in facilities, tools, or equipment. Independent contractors normally have a significant investment in what they need to perform services for someone else.

3. Relationship between parties

Relevant facts regarding the type of relationship between you and the worker include:

  • A written contract defining the relationship intended between your company and the worker.
  • Whether your business provides the worker with any benefits, such as health insurance, vacation pay or sick pay, or even pension plans. These are typically benefits reserved for employees.

Due Diligence and Playing It Safe

With the recent pressure being put on employers by both the IRS and various state agencies, it is critical that businesses be fully informed regarding the correct status and proper employee classification of all their workers.

According to the IRS website

"Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.

There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination."

If you are looking for reliable help with determining employee classification, we can help. Get your Free Download: Payroll Outsourcing Guide to help you make an informed decision or call Accuchex Payroll Management Services at 877-422-2824.

Free Download: Payroll Outsourcing Guide

Topics: independent contractors, california labor laws, labor law compliance, employee classification, IRS, employee lawsuits

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