Employee vs. Independent Contractor

Posted on July 27, 2011

Want to know how the IRS decides if someone is an employee or a subcontractor? Here is the audit guide that explains how they make that determination.

Employee or Independent Contractor (As stated in the IRS Audit Technique Guide for Business Consultants)

Behavioral Control


  1. Type of Instructions:
  • When to do the work
  • Where to do the work
  • What tools or equipment to use
  • What workers to hire to assist with the work
  • Where to purchase supplies or services
  • What work must be performed by a specific individual (including ability to hire assistants)
  • What routines or patterns must be used
  • What order or sequence to follow
  1. Prior Approval
  • Requirement to secure prior approval before taking certain actions
  1. Degree of Instruction
  • Extent of the detail of the instructions given to the worker
  • Effect on the worker in the event of noncompliance
  1. Presence of Instructions or Rules Mandated by Governmental Agencies or Industry Governing Bodies
  • Did the business impose the instructions or rules only in compliance with governmental or governing body regulations
  • Did the business adopt more stringent rules or regulations than those imposed by governmental agencies or governing bodies
  1. Instructions by Customer
  • Did the business pass on instructions given by the customer
  1. Suggestions vs. Instructions
  • Is compliance with suggestions mandatory
  1. * Business Identification
  • Reason for requiring the worker to wear a uniform or placing business name on vehicle, i.e. reassurance to customer, security purposes
  • Who incurs the expense
  1. * Worker’s Occupation
  2. * Nature of the Work
  • Degree of direction and control required by virtue of the work itself

*These aspects may be neutral in the determination of the worker’s status.

  1. Evaluation Systems
  • Measurement of Compliance with Performance Standards
    • Influence on worker’s behavior in performing the details of the job
  1. Training
  • Type of Training
    • What procedures to follow in performing the task
    • What method to use
    • Updates on company policies, governmental rules or regulations, statutes, orientation, general information sessions
    • Is attendance mandatory
    • Is the worker compensated for attending the training


Financial Control

  1. Significant Investment
  • Nature of Business
    • Type of business
    • What assets are normally acquired for the business
    • How the assets are normally acquired, i.e. purchased, leased
    • Other expenditures normally encountered in the business
    • How are the cost determined, i.e. FMV or FRV, arm’s length transaction
  1. Reimbursed v unreimbursed expenses
  • Who bears the costs of the assets and expenditures mentioned above
  • Which expenses are not reimbursed
  1. * Availability of Services
  • Whether the worker advertises his/her services
  • Location of the business
  • Whether the worker is available to work for the relevant market
  1. Method of Payment
  • Salary or hourly
  • Flat fee
  • Commission
  1. Realization of Profit or Loss
  • Freedom of choice to make decisions which have an impact on the worker’s ability to realize a profit or loss

*These aspects may be neutral in the determination of the worker’s status.

Relationship of the Parties

  1. Intent of the Parties
    1. Contractual Relationship
  • Consider substance over form
  1. Information Returns
  •  Form W-2
  • Form 1099
  1. Incorporation
  2. Benefits
  • Paid vacation days
  • Paid sick days
  • Health insurance
  • Life and/or disability insurance
  • Tax-qualifies retirement plan; Sec 403(b) annuity; other pension plan
  • Cafeteria plan
  • Status determined by state or federal agencies for purpose of providing benefits
  1. Discharge/Termination
  • Limitation on ability of the business to terminate worker
  • Limitation on ability of the worker to terminate working relations ship
  • Worker’s liability as result of non-performance
  • Business’s rights in non-performance by worker
  1. Regular Business Activity v Services Performed by Worker
  2. Term of the Relationship
    1. Definite v Indefinite Period
  • Long-term
  • Temporary
  • Written contract

Facts of Lesser Importance

  • Full-Time v Part-Time
  • Place of Work
  • Number of Work Sites
  • Hours of Work

Exhibit E

Internal Revenue Code Section 530

  1. Reporting Consistency
    Did the business timely file all required tax returns with respect to the worker (including information returns, Forms 1099) for the period under examination on a basis consistent with the business’s treatment of the worker as not being an employee?
  2. Substantive Consistency
    Worker, or Class or Workers, currently treated as independent contractors.
    1. Duties:
  • Current
  • Previous
  1. Responsibilities
  • Current
  • Previous
  1. Supervisor or Manager & Title
  • Current
  • Previous
  1. Degree of supervision & control required
  • Current
  • Previous
  1. Reasonable Basis
    1. Safe Havens:
  • Prior Examination
  1. Type of examination
  2. When was the examination conducted
  3. Were same class or workers currently under consideration, treated as independent contractors during the period covered by the prior examination
  4. Did taxpayer reasonable rely on the prior examination
  • Judicial Precedence or Published Ruling
  1. When did the business begin
  2. When did the business first begin treating its workers as independent contractor
  3. Facts in the case similar to the business’s situation
  4. Date of the ruling
  5. Did taxpayer reasonably rely on the ruling
  • Technical Advice Memorandum, Private Letter Ruling, or other
  • Determination Letter
  1. To whom/what entity was the ruling issued
  2. Were the facts materially misstated or omitted
  3. Any substantial change in the facts since the ruling was issued
  4. Did taxpayer reasonably rely on the ruling
  • Long Standing Recognized Practice of a Significant Segment of the industry
  1. When did the business begin
  2. When did the business first begin treating its workers as independent contractors
  3. How were the workers previously treated
  4. Define the industry
  5. How long has the industry existed
  6. When did the industry begin this practice
  7. Define the geographic/metropolitan area of the industry
  8. How prevalent is the practice in the industry
    1. Number of firm engaged in this practice
    2. Number of workers involved
    3. Homogeneity of the industry
    4. When did the industry’s practice change, if applicable
    5. Did taxpayer reasonably rely on the industry practice
    6. Other Reasonable Basis: (More than mere "good faith" is required for section 530 relief. "Good faith" may be basis for not asserting penalties.)

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