If this week’s headline on classifying employees looks familiar, that’s because it’s exactly like last week’s– except for the number.

Lest you think we’ve taken to making sequel flops for our posts, a la Caddy Shack II, think again. This week’s post is a follow-up to last week, covering how the IRS classifies worker tax status.

This week, we’ll cover the rules you must apply to those worker types for proper tax classification. Applying these rules to employee types can help avoid potentially severe fines and criminal penalties.

By the way, if you haven’t read last week’s post take a minute to go back and do that now.

Back? Okay, let’s go!

Classifying employees

Okay, just in case you didn’t have time to go back and read last week’s article, here’s the deal in a nutshell.

Classifying employees for tax purposes is a two-step process. Skipping either step is like riding a bike with a flat tire. You might get where you want to go, but it will be a rough ride.

First, you determine what kind of worker they are (independent contractor, common law, employee, statutory employee, or statutory nonemployee), and then you apply common law rules to complete the determination.

The common law rules are evidence of the amount of employer control and worker independence. Those rules fall into three categories: behavior control, financial control, and relationship.

The IRS and Department of Labor consider all three when determining if a worker is an employee or independent contractor.

Behavioral Control

Like many aspects of employee classification, defining behavioral control leaves plenty of gray areas to make a mistake. But the IRS does offer some basics.

It states that a worker is an employee when the employer can control and direct the worker. It doesn’t mean they do; it just means they have the right to.

Of course, that’s vague, so they break control into four categories: type of instruction given, degree of instruction, evaluation systems, and training.

Type of instruction includes the type of tools to use, where to purchase supplies, who performs specific tasks, or what order or sequence to follow when doing the work.

Degree of instruction is about details. The more detailed the instruction, the more likely the person is an employee, not a contractor.

If you have an evaluation system that measures performance, the IRS will probably view that as evidence of an employer-employee relationship. If the system only measures outcomes, it could be an employee or contractor.

Finally, if training is provided on how to do the job, the IRS considers that evidence of an employee-employer relationship. If training is frequent, that provides more evidence of that relationship.

While the amount of control is a strong barometer of employee classification, so are finances. Let’s look at those now.

Financial Control

The IRS looks at investment as an indicator of whether a worker is a contractor or an employee. Generally speaking, the more expense the worker incurs out of pocket, the more likely they are an independent contractor.

The IRS does not set a dollar amount, and the investment doesn’t have to be significant.

Unreimbursed expenses are measured, too. If the worker has fixed ongoing costs, whether or not work is being performed, the IRS looks at them as contractors.

Of course, it can be argued that employees like construction workers and teachers incur significant investments such as tool purchases and classroom equipment. The difference here is that they have less opportunity for overall profit or loss due to their investments.  The chance to lose money on a job indicates a contractor in the eyes of the IRS.

Construction workers and teachers also receive a regular wage. According to the IRS, that is a telltale sign of an employee. It contends that contractors usually receive a flat fee for a job.

So, expenses, profit and loss, and payment methods all play a role in financial control.

But there’s one more stipulation. The IRS maintains that if the worker advertises their services and is free to seek other business opportunities while under contract, that is evidence of being an independent contractor.

Speaking of contracts, that brings us to the last area of control.

Type of Relationship

Just because a worker has a contract stipulating they are an independent contractor doesn’t mean the IRS will classify them that way.

It all comes down to the relationship. If a business hires someone with the idea the relationship is indefinite, the IRS will consider that evidence that they are an employee.

And if the business views the services provided by a worker as its own, that’s more evidence of an employee-employer relationship.

The Bottom Line

Classifying employees correctly is no small task. But if you understand the type of worker and properly apply the common law rules, you’ll have a stronger case if the classification is ever called into question. Still, there are plenty of opportunities to make a very costly mistake.

The best course of action is to know the rules well and seek out the advice of a business attorney when there are questions.