Classifying Employees vs. Independent Contractors: Part 2 – The IRS 20 Factor Rule

Classifying Employees vs. Independent Contractors: Part 2 – The IRS 20 Factor Rule

In our last post, we focused on the danger of misclassifying workers as 1099 independent contractors instead of as W2 employees – a growing problem in a time when companies are looking for ways to cut corners. Organizations in South Florida and around the U.S. have experienced crushing blows from the Internal Revenue Service (IRS) when it comes to not following the rules. For example, several companies were fined in the hundreds of millions of dollars for failing to report their workers as employee status. 

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A special report issued over the summer by the U.S. Department of the Treasury – Treasury Inspector General for Tax Administration (TIGTA), aptly titled, Employers Do Not Always Follow Internal Revenue Service Worker Determination Rulings, audited a group of 5,067 employers finding that almost 20 percent did not comply with IRS guidelines for taxpayer filing status. This error resulted in nearly $6 million in employment taxes not being calculated properly for the study tax years of 2008 to 2010.

How Can Employers Avoid Being Sued by the IRS for Misclassification of Employees and Independent Contractors?

Fortunately, the IRS provides a handbook that helps employers determine if they must treat their workers as independent contractors or employees for payroll taxes and filing purposes. Referred to as the IRS 20 Factor Rule, this is list of 20 factors that are essentially a litmus test to determine if a worker meets the requirements to be an employee or if the business can simply send a 1099 at year’s end.

To save you from having to read the entire booklet, here is a general breakdown of IRS 20 Factor Rule, as approved by the IRS guidelines.

  • Behavioral Control – A good number of the list of 20 factors fall under the behavioral aspects of the working relationship. The IRS describes this as to what extend the business entity is given the right to direct and control the work performed, how it is completed, and if any training or supervision is in place. For example, if a worker must report during a specific shift or work a certain amount of time on-site, this can constitute a W2 payroll status.
  • Financial Control – These are the other subset of factors that make up the main list to observe when determining worker status. Financial factors in this category are any that allow the business to control the earnings and other business aspects of the worker’s occupation. So this could include paying a worker by the hour vs. by the project, if the worker can provide services to others, and if the worker uses his or her own tools to get the job done.
  • Relationship of the Parties – In this somewhat tricky set of classification factors, the IRS determines if an employee-employer status is present or not, based on the relationship of both parties. So, for example, if the business provides benefits like health insurance or paid vacation to the worker, this could constitute a W2 status and not an independent contractor status.

It’s important to note that the mere presence of a written independent contractor agreement does not establish a 1099 status for payroll processing. The IRS 20 Factor Rule should be evaluated against the actual working arrangements of any worker in order to avoid being penalized for not reporting the correct IC or employee status. Reference the full IRS 20 Factor test, available on the IRS website for more information.

SourceOne Partners is comprised of an experienced team of payroll professionals that can help you find a payroll company that fits your specific needs. With offices in South Florida and New Jersey, we can help you find a solution to better manage your payroll services, employee benefits and company taxes so that you can save time, money and avoid the penalties of non-compliance. Please call 561-674-0748 to speak with a payroll expert or click here to contact us online.