Employee or Independent Contractor: Making the Best Decision from IRS guidelines
Since the dawn of withholding and the requirement that employers match Social Security and Medicare taxes and provide benefits for full time employees, there has been a struggle between employers and the IRS over whether a worker should be considered an employee or an independent contractor. In the past, courts and the IRS have cobbled together various tests. These would often function as checklists, guiding employers on how to categorize their workers. But the tests grew more complex. In response to the resulting confusion, the IRS changed its approach to classifying workers (although some of the principles remain the same).
I. Why Does This Matter?
Determining the status of your workers is essential to avoiding reclassification and its consequences. For example, if an exempt organization incorrectly classifies a worker as an independent contractor, the IRS can assess employment taxes, interest, and penalties if the agency detects and corrects the employee misclassification. The resulting costs could exceed thousands of dollars.1
Factors of control and independence govern the analysis for employee vs. independent contractor. In a Continuing Professional Education (CPE) article, authors Kawecki and Henzke describe the standards as follows:
To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered.2
Consistent with the emphasis on control and independence, there are a variety of tests to determine the status of the employee. The “Common Law Test” and the “Tax Court 7-Factor Test” discussed below encapsulate the central issues of control vs. independence.
II. IRS Rulings Based on the Common Law Test
Shortly after the IRS published its new procedures in the CPE text, the agency began issuing rulings illustrating the novel principles.
In one of the first rulings, the IRS considered a teacher whom a school initially hired as a contract worker.3 The teacher taught seven classes during an eight-hour workday on the premises of the school, and he did not teach for other schools. The school provided the worker with training, and he was required to attend weekly staff meetings. If substitutes or helpers were needed, the school hired and paid them. If problems arose, he was required to contact his supervisor, the principal. The school also required the teacher to report student attendance and progress. The school provided all educational supplies and did not require the teacher to incur any personal expenses. The teacher also was entitled to vacation and sick leave. Both the worker and the school could terminate their ongoing relationship at any time, without incurring liability or penalties.
The IRS ruled that “the services performed by the Worker were sufficiently subject to the direction and control by the Firm to establish an employer-employee relationship.”4 The IRS reached its conclusion by referring to the three primary factors announced in the 2003 CPE text – behavioral control, financial control, and the relationship of the parties:
Behavioral controls. These “are evidenced by facts which illustrate whether the service recipient has a right to direct or control how the worker performs the specific tasks for which he or she is hired. Facts which illustrate whether there is a right to control how a worker performs a task include the provision of training or instruction.”5
Financial controls. These “are evidenced by facts which illustrate whether the service recipient has a right to direct or control the financial aspects of the worker’s activities. These factors include whether a worker has made a significant investment, has unreimbursed expenses, and makes services available to the relevant market; the method of payment; and the opportunity for profit or loss.”6
The relationship of the parties. This “is generally evidenced by the parties’ agreements and actions with respect to each other, including facts which show not only how they perceive their own relationship but also how they represent their relationship to others. Facts which illustrate how the parties perceive their relationship include the intent of the parties as expressed in written contracts, the provision of or lack of employee benefits, the right of the parties to terminate the relationship, the permanency of the relationship, and whether the services performed are part of the service recipient’s regular business activities.’”7
III. The 7-Factor Tax Court Test
The U.S. Tax Court has established a similar test that involves a few more factors to flesh out the relationship between control and independence. This test is based on the same principles and includes the following seven factors:
- Degree of control exercised by the employer over the details of the work.
- Which party invests in the facilities used in the work.
- Opportunity of the individual for profit or loss.
- Whether the employer has the right to discharge the worker.
- Whether the work is part of the employer’s regular business.
- Permanency of the relationship.
- Relationship the parties believe they are creating.8
The Tax Court in Weber v. Commissioner developed and applied this test for purposes of federal income tax, when the court held that a minister was considered an employee—not an independent contractor or self-employed.9
a. Degree of control exercised by the employer over the details of the work
The Fourth Circuit has noted that the control factor is generally the most persuasive factor and is crucial to the analysis of the working relationship between the parties.10 The more control the employer exercises over the details of the work, the more likely the worker is an employee. This factor is important, not just in determining what control the employer actually exercised, but also the amount of control the employer may exercise over the employee. This degree varies according to the nature of the work. For example, the court established that for a professional employee, such as a minister or a doctor, the threshold of control necessary for an employee relationship is much lower than it would be for a non-professional worker.11 The court therefore considers how realistic it would be for the employer to control the details of the particular work performed by the particular worker in question.
In Weber, the court found that the following factors showed a sufficient degree of control over the minister’s work:
- Weber was required to perform the duties set forth by the United Methodist Church’s Discipline, and he agreed to do so.
- Weber followed United Methodist theology in his sermons.
- A Methodist bishop testified that the church was proactive in running the church, and that none of its members worked without supervision;.
- Weber had to explain the position of the United Methodist Discipline on any sermon topic.
- Weber did not have unilateral authority to stop the regular services at the local church.
- The minister was appointed to his position by the Methodist Conference, was told where he would be preaching, and could not refuse the appointment.
- Weber could not establish his own church.
- Testimony showed that a minister in the Methodist Conference could be terminated for unfit or ineffective service and that there was a system in place to monitor and supervise ministers.
- Weber was bound by the Methodist Discipline’s policies on retirement and leave, and was required to obtain approval before transferring to a different Conference.12
Under these factors, the court found that Weber was subject to a significant amount of control, even taking into consideration the fact that he was a professional, and that control over professionals is necessarily more tenuous and general than control over non-professionals.13
b. Which party invests in the facilities used in the work
If the employer invests in or provides facilities for the worker to use, it is more likely that the worker is an employee. In Weber, the church provided facilities and tools for the pastor, including a house for him, a church for preaching, and office space and religious materials.14 The fact that the pastor chose to perform some work at home and not in the office, and that he chose to purchase a personal computer for his work, did not negate the fact that he was not required to provide his own equipment or workspace.15
c. Opportunity of the individual for profit or loss
Workers who are self-employed generally can realize a profit or suffer a loss as result of their services or due to any sudden inability to perform their services. Their profit is tied to what product or service they can provide; if they fail to provide, they lose the profit, but if they are able to provide more produce or service to several customers, they may increase their profit. Employees, on the other hand, receive a guaranteed salary and benefits. In Weber, the pastor was not at risk for loss of profit, since he was paid on a salary basis, received utility and travel expenses guaranteed, and received a parsonage for living.16 He also lacked the ability to increase his income in any significant way; hence he was more likely an employee than an independent contractor.17
d. Whether the employer has the right to discharge the worker
While an employee may not have much risk of losing profit, he is generally subject to employment decisions of his employer, including discipline and termination. An independent contractor is not subject to those same employment decisions. In Weber, the minister was more like an employee because the Methodist Conference had the authority to “try, reprove, suspend, deprive of ministerial office and credentials, expel or acquit, or locate . . . [Pastor Weber] for unacceptability or inefficiency.”18
e. Whether the work is part of the employer’s regular business
If the worker is furthering the employer’s regular or customary business, he is more likely to be classified as an employee. Pastor Weber’s services of preaching and leading the local church in accordance with Methodist doctrine were an integral part of the Methodist Church, making his position part of the employer’s regular and customary business.19
f. Permanency of the relationship
Whenever a worker is in a relationship with the employer that is long-term, permanent, exclusive, and measured by years of commitment and not by jobs performed, he is more likely to be an employee and not an independent contractor. For example, Pastor Weber admitted that his position as a minister with the Methodist church would likely continue for the rest of his professional career, and that he would likely remain affiliated with the Methodist Conference where he was located.20 He did not offer his services to the general public, and he was required to work at a particular church and attend the meetings there.21 He did not work for individuals by the “job,” but worked for the church year by year.22 The court found that such a continuing and permanent relationship evidenced an employee relationship.23
g. The kind of relationship the parties believed they were creating
Courts give this factor little weight, particularly if the practical nature of the relationship as shown by the other factors weighs in favor of an employer/employee relationship. Nevertheless, the court looks at the intent of the parties in constructing their relationship, including whether the worker is issued a W-2 form, whether the employer withholds taxes from the worker’s pay, and whether the worker receives fringe benefits that employees typically receive.24
In Weber, although the church did not issue the pastor a W-2 and did not withhold taxes, the pastor received a large amount of fringe benefits that are typically issued to employees, including pension benefits, paid vacation, disability and paternity leave when needed, a percentage of life insurance cost, and a percentage of health insurance premiums.25 All of these benefits showed he was an employee rather than independent contractor, despite the fact that no taxes were withheld from his wages.
IV. Court Rulings Based on the 7-Factor Test
The District Court in LA Nails, Inc. v. United States applied these same factors to find that manicurists who worked at a nail salon were employees, not independent contractors.26 The court noted that several factors tended to show that the workers might be independent contractors, including the following:
- The manicurists were professionals.
- They set their own hours.
- They furnished one of their own tools and some optional supplies.
- They had access to the premises.
- They were paid on a commission basis.27
Nevertheless, the court found these factors could not outweigh the evidence showing that the manicurists’ true relationship was as employees, based on the following factors:
- The salon where they worked was leased by the employer.
- The employer owned the workers’ work stations.
- The employer provided the supplies, except for one tool.
- The employer issued the pay checks.
- The employer had the right to fire the workers at any time, and the workers could quit at any time.
- The workers could not subcontract.
- The workers typically worked for the employer for several years, on average, and had little exposure to business loss.
- The employer paid insurance, telephone, advertising, utilities, and similar business expenses.
- The employer’s receptionist, not the workers, typically resolved customer complaints.28
Similarly, the court in Eren v. Commissioner confirmed a worker’s status as employee, using the test from Weber.29 Eren worked under a contract stating that he would “inspect construction, improvements and/or repairs at project sites and will be directly responsible to [his employer] FBO in the performance of his duties . . . .”30 Several other factors contributed to a finding of “employee”:
- Eren was required to obey his “Contracting Officer,” and he was bound by the employer’s Project Director Handbook.
- One of the contracting officers monitored Eren’s work, had authority to expand or limit his authority, and required him to submit mandatory monthly progress reports.
- While Eren had authority to hire or fire his own staff, the employer held and paid the staff contracts.
- Eren was paid at the direction of his employer, who dictated his hours and his leave.
- Eren received a fixed salary that was contingent on a minimum of a 40-hour work week rather than the completion of the project, and although he did not receive retirement benefits, he was entitled to annual leave, sick leave, and home leave.31
The court also considered that Eren’s relationship with the employer was long-term and permanent because he had worked exclusively for the employer for over a decade.32 The parties had also agreed that Eren did not suffer a risk of loss for his services, even though he could lose a slight profit on individual contracts.33 The court ultimately held that, although it was a close case, the Tax Court had not clearly erred in finding that Eren was an employee under these factors.34
V. Virginia Employment Law Changes
In addition to the federal penalties described above, Virginia recently updated its laws to permit employees to seek damages and attorneys’ fees for misclassifying the employees at the state level. Virginia now presumes that a worker is an “employee” unless the employer proves that the worker is an independent contractor under the IRS rules outlined above.
a. Private causes of action
Starting in July 2020, workers can sue their employers directly for knowingly misclassifying them as independent contractors.35 Because the Commonwealth will presume the worker to be an employee, the employer will have the burden to show that the worker is an independent contractor and not an employee. If the employer fails to prove this, the worker would be entitled to lost wages, benefits, expenses (including health insurance), attorneys’ fees, and court costs.
Unfortunately, the amendment did not define “knowledge” as either actual or constructive, and courts have not yet addressed this question. Thus, ensuring that workers are properly classified prior to hiring is even more important to avoid litigation.
b. No retaliation
As a companion to the above statutory presumption, the General Assembly also instituted a “no retaliation” statute to curb employers from taking potential negative actions against workers who report a misclassification.36 Under this amendment, an employer may not retaliate against an employee or independent contractor who (1) reports or intends to report a misclassification, or (2) is requested or subpoenaed to participate in an investigation of misclassification.37 If the employer does retaliate, it can be subject to civil penalties up to the worker’s lost wages.38
However, the employee claiming retaliation with the Virginia Commissioner of Labor and Industry must provide evidence that the misclassification accusation is supported by a “reasonable belief” and “in good faith.”39
c. Employer penalties and back taxes owed for misclassification
Beginning in January 2021, employers who misclassify an employee will be required to pay all proper back taxes, benefits, and other contributions to the employee, along with a civil penalty to the Commonwealth.40 The civil penalties accrue as follows:
- First offense: Up to $1,000 per misclassified worker.
- Second offense: Up to $2,500 per misclassified worker.
- Third or more offense: Up to $5,000 per misclassified worker.41
Further, these amendments make it unlawful for an employer to require a worker to enter into any agreement or sign a document that results in a misclassification, inaccurately depicts the relationship, or permits adverse action against a worker who does report a misclassification.42
d. State agencies sharing information
In 2021, the General Assembly authorized the Tax Commissioner to exchange employment tax information with other state agencies (e.g., the Virginia Employment Commission, the Virginia Workers’ Compensation Commission, etc.) to help identify and penalize employers that misclassified workers.43 This information sharing among the relevant state agencies could result in multiple applicable penalties and fines on employers who misclassify their workers.
With these amendments, a Virginia employer who misclassifies an employee as an independent contractor could be required to pay back taxes, benefits, and other employee contributions owed for the length of the employment. The employer might also suffer significant civil penalties to the state. If the employer knew that it was misclassifying the employee, the employee would also be entitled to attorneys’ fees and court costs paid to bring the lawsuit.
Further, an employer would not be able to rely on a written independent contractor agreement as a defense if the employer knew it was misclassifying the employee and misrepresented the employer-employee relationship.
In determining whether a worker should be considered an employee or an independent contractor, be sure to use the three tests of behavioral control, financial control, and type of relationship—and incorporate the additional 7-factor test to flesh out these three governing principles. Although these standards are somewhat complex, it is important to remember that the IRS presumes workers to be employees unless proven otherwise. Day-to-day supervision will always be a controlling factor in the tests that you apply. In short, the IRS and Virginia have a strong bias against treating workers as independent contractors, and they will impose significant penalties and fines against an employer who misclassifies its employees. When unsure about classification, assume that your workers are employees and withhold taxes. That choice—although more costly short-term—will save significant long-term time and expense. Most importantly, every employer should seek legal counsel from a lawyer experienced in church and nonprofit employment law.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. If you would like to purchase the longer memo with more detailed advice, please contact us at 703.771.4671 or JQuan@simmsshowerslaw.com. Please contact Robert Showers at email@example.com, Kyle Winey at firstname.lastname@example.org, or Justin Coleman at email@example.com for specific legal advice on this issue for your needs.
Exempt Organizations: Independent Contractors vs. Employees, Internal Revenue Service, https://www.irs.gov/charities-non-profits/exempt-organizations-independent-contractors-vs-employees (last visited March 24, 2023).↩︎
Debra Kawecki and Leonard Henzke, Employment Tax Update – Review of Current Litigation, 2003 EO CPE Text, 3 (2013), http://www.irs.gov/pub/irs-tege/eotopicd03.pdf.↩︎
I.R.S. Priv. Ltr. Rul. 200324043 (March 10, 2003).↩︎
See Weber v. Comm’r, 103 T.C. 378, 387 (1994), aff’d, 60 F.3d 1104, 1114 (4th Cir. 1995).↩︎
Id. at 386.↩︎
See Weber v. Comm’r, 60 F.3d 1104, 1112 (4th Cir. 1995).↩︎
See Weber, 103 T.C. at 388.↩︎
Seeid. at 384–90.↩︎
Seeid. at 393.↩︎
Id. at 390.↩︎
Id. at 391.↩︎
See id. at 391–92.↩︎
Id. at 392.↩︎
See id. at 394.↩︎
See id. at 392–93.↩︎
Id. at 393.↩︎
See LA Nails, Inc. v. United States, 1998 U.S. Dist. LEXIS 7733, *5–8 (D. Md. 1998).↩︎
Id. at *7.↩︎
Id. at *6–7.↩︎
See Eren v. Comm’r, 180 F.3d 594, 596–97 (4th Cir. 1999) (reviewing a Tax Court judgment under the “clear error” standard); see also Schultz v. Cap. Int’l Sec., Inc., 466 F.3d 298 (4th Cir. 2006) (applying a similar 6-factor test to determine that security workers were employees).↩︎
Id. at 596.↩︎
Id. at 596–97.↩︎
Id. at 597.↩︎
See id. at 597–98.↩︎
Va. Code. Ann. § 40.1-28.7:7(A) (LEXIS through 2023 Leg. Sess.).↩︎
Id. at § 40.1-33.1.↩︎
Id. at § 40.1-33.1(A).↩︎
Id. at § 40.1-33.1(D).↩︎
Id. at § 40.1-33.1(B).↩︎
Id. at §§ 58.1-1900 to -1905.↩︎
Id. at § 58.1-1901.↩︎
Id. at § 58.1-1903.↩︎
Id. at § 58.1-3.4.↩︎