The use of “consultants” is a widespread practice in industry. The practice is encouraged by factors such as the transient nature of most contracts, the need for specialized expertise for particular projects, and the long lead time in obtaining contracts. For these and other reasons, contractors often seek to engage consultants on a “temporary” basis in place of hiring full-time employees. Although the hourly compensation rate for a consultant can substantially exceed that of a full-time employee, the employer is not faced with the need to provide fringe benefits, and can avoid the trauma that accompanies the discharge of employees no longer needed to perform a specific contract.
In most cases, the contractor will attempt to treat a consultant as an independent contractor, thus avoiding the need to withhold Federal and state income taxes and the payment of FUTA, SUTA, FICA and workman’s compensation premiums.
Contrary to common belief, the mere designation of a worker as a consultant does not automatically confer upon the worker the status of an independent contractor. In fact, the task of determining whether or not a worker is an independent contractor is often a difficult one. In making such determinations, the IRS focuses on the concept of control. Revenue ruling 87-41 states that:
generally the relationship of employer and employee exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.
In this same Revenue ruling, the IRS lists and describes twenty factors to be considered in differentiating between employees and independent contractors. Employers can use these factors, which were developed from past court cases and rulings, in evaluating their own workforces to determine that workers are appropriately classified. It is important to understand that the weight to be given to each factor will vary depending on each individual situation. Often the occupation of the particular worker being classified will be of paramount importance in determining which factors are most relevant.
Based on the factors in Revenue Ruling 87-41, summarized on this page, companies should assess their current practices in regard to their treatment of consultants and subcontractors for withholding and payroll tax purposes. Keep in mind that improper classification of employees as independent contractors could expose a company to substantial liability for the payment of back taxes if the IRS were to successfully challenge the treatment. The extent to which penalties and interest are assessed on such liabilities is dependent on whether the misclassification creating the liability is deemed by the IRS to have been intentional. A company should also be aware that each time it files the required Form 1099- MISC for payments to an independent contractor, it is providing notice to the IRS. In addition, there is always the possibility that a disgruntled “consultant” will later allege that an employer-employee relationship existed in an attempt to hold the employer liable for withholding and payroll taxes. Accordingly, companies should be careful to document consulting arrangements in a written agreement which clearly delineates the rights and responsibilities of the parties.
Factors in Revenue Ruling 87-41
- 1. Is the worker subject to the employer’s instructions?
- A worker who is required to comply with the employer’s instructions as to when, where and how work is to be done is most likely an employee. It is only required that an employer have the right to control the worker, whether or not the control is implemented is irrelevant.
- 2. Does the employer provide training?
- Any form of employer-provided training suggests an employee-employer relationship since training implies that the work needs to be performed in a particular manner. The IRS defines training in very broad terms.
- 3. What is the degree of integration of the services into the business?
- If the success of the services performed by the individual is crucial to the success of the business as a whole, control over the services is presumed to exist. The greater the degree of integration of the work into the business, the greater the likelihood that an employer-employee relationship exists.
- 4. Are the services rendered personally by the worker?
- Services required to be performed in person by the worker tend to indicate control, especially when the employer has an interest in how the results are achieved.
- 5. Who is responsible for hiring, supervising and paying assistants?
- Hiring, directing, or paying assistants, when done by the employer, shows an employee-employer arrangement. Independent contractors hire, direct and pay their own people.
- 6. Does a continuing relationship exist?
- Continuing work by the individual, even if not regular, points toward an employer-employee relationship.
- 7. Does the employer set hours of work?
- Designating hours of work demonstrates control over the worker.
- 8. Is full-time work required?
- Utilizing a worker on a full-time basis precludes the worker from pursuing other work and is an indication of control.
- 9. Is the person doing work on the employer’s premises?
- Performing work away from the employer’s offices reduces the thread of control. While some independent contractors do work on the employer’s premises, this tends to indicate greater control by the employer.
- 10. Is the work order or sequences set by the employer?
- Following routines or work patterns established by the employer is indicative of employee status.
- 11. Are oral or written reports required?
- The requiring of regular progress reports demonstrates control.
- 12. Is payment by the hour, week or month?
- Payment on a fixed periodic basis, rather than upon completion of the work, is an indicator of employee status.
- 13. Does the employer make payment of business and/or traveling expenses?
- The payment of these expenses by the employer points to regulation of business activities and thus indicates employee status.
- 14. Is the employer responsible for the furnishing of tools and materials?
- Independent contractors normally provide their own tools and materials.
- 15. Is the worker required to make a significant investment to perform the work?
- The making of a substantial investment by the worker, e.g. rental of a facility, tends to support the existence of independence.
- 16. Does performance result in realization of profit or loss?
- The ability to realize either a profit or a loss in performing the work is a characteristic of an independent contractor.
- 17. Is the individual working for more than one firm at a time?
- The performance of services for several customers simultaneously is typical of an independent contractor.
- 18. Is the individual engaged in making service available to the general public?
- Marketing one’s services to the general public indicates independence.
- 19. Does the employer have a unilateral right to discharge the worker?
- The right to discharge at will indicates an employer-employee relationship. Independent contractors typically can only be discharged for failure to meet contract requirements.
- 20. Does the worker have a unilateral right to terminate his services?
- An employee may resign at will, but an independent contractor may be contractually obligated to perform.
Copyright © 1993 Friedman & Fuller, P.C.