Independent Contractor Rules
U.S. Employee (W-2) OR Contractor (1099-NEC) Guidelines

Published September 2011 | Updated June 6, 2024 | Revised November 30, 2024

WHAT'S IN THIS ARTICLE
How The IRS Audits ICs | Form 1099-NEC and 1099-NEC | Definition of an Employee | What are the IC Rules? | Yearend Compliance Reminders | Stiff Penalties for Non-Compliance | Who Should Get a 1099-NEC? | Completing 1099 Forms | US Citizen Employed By Canadian Company | Written Agreement Checklist | Voluntary Classification Settlement Program | Who Cares?

Independent contractor rules assist the IRS in determining whether you have correctly classified your employees and contractors.

Employee payroll tax rates and benefits are more costly to the employer. It can be advantageous to hire an independent contractor (IC) instead of an employee ... that's why it is a frequently audited area.

Make sure you verify that your independent contractors actually meet the criteria ... and are not really employees.

Consider viewing the 2015 IRS webcast on Payments to Independent Contractors or download the transcript ... choose your preference. (I hope IRS update the format for this webcast as Adobe Flash was discontinued in 2021 and the webcast requires it to view.)

INDEX for Federal Payroll Taxes Series

How IRS Audits For The Independent Contractor Rules

At the American Payroll Association's (APA) 29th Annual Congress, Steve Hodgson, CPP explained that one way the IRS audit independent contractors is through the 1099 Matching Program.

IRS auditors look at individuals who have only filed one Form 1099-NEC (1099-MISC prior to 2020)  indicating they may be an employee and not a contractor; or individuals who receive a 1099-NEC (Form 1099-MISC before 2020) from the same business in more than one year.

Definition of an Employee

• Federal Income Tax (FIT) Definition of Employee: The FIT definition of an employee is based on common law principles, which consider the degree of control and independence in the working relationship.
  
  
• FICA/FUTA Definition of Employee: The Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) generally follow the common law definition of an employee, with some specific exceptions.

What Are The Independent Contractor Rules?

The IRS have an excellent 2 page pamphlet (publication 1779) that discusses the subject. It is concise, easy to read. It is titled Independent Contractor or Employee and can be found at www.irs.gov/pub/irs-pdf/p1779.pdf .

This pamphlet looks at the three categories the courts have considered when determining whether a person is an employee or an independent contractor:

1. behavioral control-right to direct or control how the work is done such as who gives instructions and provides necessary training;
2. financial control - right to direct or control the business arrangement including how expenses are handled; and
3. relationship of the parties - how the parties perceive their relationship including evidence of a written contract and/or employee benefits.

The State of Nevada Labor website (labor.nv.gov) has a list of the "old" IRS 20-Factor Test: Independent Contractor or Employee that lays out the independent contractor rules. It was developed to help employers evaluate whether a worker was an employee or an independent contractor. The 20 items checklist identified below all fit into one of the IRS's three categories of independent contractor rules shown above.

I've listed the independent contractor's checklist listed in the Fact Sheet and added which IRS category I think they fall under:

1. Instructions - behavioral control 
2. Training - behavioral control 
3. Integration - behavioral control
4. Services rendered personally - relationship of the parties 
5. Hiring assistants - behavioral control
6. Continuing relationship - relationship of the parties
7. Set hours of work - behavioral control
8. Full time required - relationship of the parties
9. Work done on premises - behavioral control
10. Order or sequence set - behavioral control
11. Reports - relationship of the parties
12. Payment method - financial control
13. Expense reimbursement - financial control
14. Tools and materials - behavioral control
15. Investment - financial control 
16. Profit or loss - financial control 
17. Works for more than one person at a time - behavioral control 
18. Services available to general public - relationship of the parties
19. Right to fire - relationship of the parties
20. Right to quit - relationship of the parties

Answer these questions to help determine if you are an independent contractor or an employee:

• Do you receive a 1099-NEC ... or a W-2?
• Are you responsible for paying your own taxes ... or are they deducted from for you from your remuneration?
• Do you file a Schedule-C to report your expenses ... or are they reimbursed on Schedule-A?

Prior to 2021, independent contractors received a 1099-MISC which recognized their compensation in box 7. As of 2021, independent contractors (non-employee compensation) receive a 1099-NEC. They will use the tax slip to calculate and pay their own taxes and may deduct expenses on Schedule-C when filing their income tax return.

TIP
State-level determinations of worker classification are becoming increasingly narrow, with many states adopting stricter criteria for independent contractor status.

According to Jean Murray in What Factors Does the IRS Look at in Determining Independent Contractor Status?, the IRS does not look at any one factor but at the "whole" picture the answers to the questions create. Jean also mentions that IRS starts with the presumption that the worker is an employee.

AIPB's free newsletter dated October 1, 2012 reviewed an IRS court case they won and the individuals were classified as employees rather than independent contractors. The court stated the facts and circumstances they used to make their decision were:

1. the degree of control exercised by the principal;
2. which party invests in the work facilities used by the worker;
3. opportunity of the individual for profit or loss;
4. whether the principal can discharge the individual;
5. whether the work is part of the principal’s regular business;
6. the permanency of the relationship; and
7. the relationship the parties believed they were creating.

Penalties Are Stiff For Not Following
The Independent Contractor Rules

An article by Nina Kaufman, Esq. from Ask the Business Lawyer.com on How Independent Contractor Agreements Protect your Pocketbook explains one of the ways government raises revenue is by "more closely enforcing their laws, and levying penalties against those who violate them."

If you intentionally misclassify a worker as an independent contractor, the IRS can reclassify the worker as an employee.

When this happens, the employer (that would be YOU) would be responsible to pay ALL related payroll taxes and withholdings including the employee's portion ... plus late payment penalties and interest. If this happens to you, make sure you get legal advice on safe haven provisions as it pertains to your situation.

The IRS can also assess failing to pay employment taxes and failing to file required tax form penalties. State penalties also apply.

The employee payroll tax penalties are reduced if the worker was unintentionally misclassified. NACB Payroll Tax Update reports:

"The IRS penalty for unintentionally failing to withhold federal income tax is 1.5% of the wages paid. This assessment is doubled to 3% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS. The IRS penalty for unintentionally not withholding the employee's share of Social Security and Medicare taxes is 20% of the employee's share of the tax. The penalty is doubled to 40% if the employer failed to file an information return for the worker with the IRS."

Nina explains that a written agreement can be a valuable weapon if/when one of these three scenarios puts YOU as a small business owner on the IRS's radar.

1. "The service provider freelances for you while working full time for another company. When laid off, the service provider lists you as someone she’s done work for in the previous year.
2. You provide an independent contractor with a long-term assignment. Because of the economy and your budget constraints, you need to let the person go. Disgruntled, he files a claim for unemployment benefits.
3. A freelancer gets injured while performing services on your job site. Somehow, the claim gets filed through Workers’ Compensation."

If you decide you need more information about the independent contractor rules, an additional reference to consult is the IRS Publication 15-A Employer's Supplemental Tax Guide.

If after reading the IRS information you still aren't sure how to classify your worker ... employee payroll tax help is available. Ask for an IRS ruling by filing Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Another good resource you might want to tap into for independent contractor rules is SBA.GOV (www.sba.gov)> establishing a business> hiring> independent contractors vs. employees.

They published a great article on November 7, 2011 titled, "How to Use Subcontractors to Save Money and Increase Business Agility" by Caron Beesley. You can locate it at SBA.GOV> Community Home> Community blogs> Small Business Cents. It discusses the pros and cons of working with subcontractors.

SBA.GOV (formerly Business.GOV) is the official business link to the U.S. Government.

Written Agreement Checklist

Robert Woods, tax lawyer, author and blogger wrote, in a checklist about the independent contractor (IC) rules, about what to include in a written agreement.

The written agreement should cover who has "the right to control the manner in which services are performed. Consider obligating the employer to pay for a finished product."

All you efficient bookkeepers out there, take note. Mr. Woods says the contract should NOT be a template. Use the checklist to customize each written agreement and state the facts of each agreement by clearly discussing the following independent contractor rules.

1. Name and Titles - clearly state it is an independent contracting agreement, name the person performing the service, avoid employee terms
   
2. Instructions and Training - the IC, not the company, determines the when, where and how and provides their own training. The company can detail the final product specifications.
   
3. Right to Delegate - IC can assign, manage and monitor their own employees' work on the contract; ICs can hire assistants, etc.
   
4. Duration and Hours - a shorter contract is better than a longer contract; scheduling of work is IC's responsibility.
   
5. Full Time and Exclusivity - rather than state hours required, state a final product deadline. The IC should have more than one client.
   
6. Work Site and Reports - IC determines where work is performed; reporting requirements (written or oral) should not be mentioned/required in the agreement. A final report upon completion of final product is okay.
   
7. Payments and Expenses - Generally avoid reimbursements; travel reimbursement is acceptable if contract contains the provisions; payment is made on presentation of invoice(s) which is preferably not billed by the hour, week or month but on progress of contract completion.
   
8. Equipment and Investment - state that they are supplied by IC
   
9. Profit or Loss and the Public - IC responsible for economic risks; IC should not be backstopped by company.
   
10. Discharge and Termination - IC includes termination provisions; there should be a liability clause to the company if they terminate the agreement.
    

To read Mr. Woods entire article, which I recommend, Bing/Google "Ten Tips for Drafting Independent Contractor Agreements". You are looking for the Daily Tax Report Vol. 10, No. 125 July 1, 2010.

You may also want to read Robert Wood's article in Daily Tax Report Vol. 9, No. 195 from October 13, 2009 titled "Ten Things GAO Has to Say About Employee/Contractor Misclassification".

P.S. I love almost anything written by Mr. Woods. You can find a list of all his published articles from the 1980s to now on his website woodllp.com.

Independent Contractor Rules Update
IRS Voluntary Classification Settlement Program

On September 5, 2011, the IRS introduced a new program that allows tax relief to eligible taxpayers for reclassifying independent contractors as employees. The program is called Voluntary Classification Settlement Program (VCSP).

The program was modified in 2012.

If you have consistently (for the past 3 years) followed the independent contractor rules by treating your workers as independent contractors AND filed all the associated Form 1099-MISC paperwork AND are not currently under audit BUT want to prospectively treat them as employees THEN file Form 8952 60 days before you begin the reclassification.

It does require you enter into an agreement with the IRS agreeing to pay 10% of the amount of employment taxes calculated with NO penalties and interest AND you will NOT be subject to an employment tax audit for the prior years.

Announcement 2011-64 at www.irs.gov/pub/irs-drop/a-11-64.pdf was superceded by Announcement 2012-45 at www.irs.gov/pub/irs-drop/a-12-45.pdf. Visit the IRS website for more information.

TIP
Safe Harbor Provisions Section 530 of the Revenue Act of 1978 provides some protection for businesses that have consistently treated workers as independent contractors.

Multiple agencies are involved in auditing and enforcing proper worker classification besides the IRS, including:

• Department of Labor (DOL)
• State tax agencies
• State unemployment agencies
• State workers' compensation boards

These agencies are concerned with ensuring proper tax collection, fair labor practices, and appropriate benefits for workers.

I'll close this chat on independent contractor rules by quoting Nina's article mentioned above.

"If your company uses independent contractors to staff its work force, be very careful that you do this properly. You want to be sure to use people who can properly be classified as independent contractors and are not just part-time employees in disguise."

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