Understanding IRS Worker Classification: From the 20-Factor to three-Category Test
Understanding IRS Worker Classification: From the 20-Factor to Three-Category Test
Distinguishing between an independent contractor and a W2 worker is crucial for several reasons, impacting both businesses and workers in significant ways:
Proper classification of individuals as independent contractors or W2 workers is essential for legal compliance, financial stability, and fair treatment of them. It has wide-ranging implications for taxation, benefits, labor laws, and business operations.
When deciding if someone is an independent contractor or a W2 worker, the IRS used to use a list of 20 factors, like a checklist, to help make that decision clear. The new evolution of this test, the three key categories test, is currently used in seven states: Arkansas, Indiana, Missouri, Ohio, Rhode Island, Tennessee, and Virginia, with the remaining states having their own tests and standards. This is really important nowadays, as the consequences for misclassification have become more severe universally.
Basically, the IRS used to look at certain factors to figure out if a worker is their own boss (an independent contractor) or works for someone else (a W2 Worker ). In the past, they used a special checklist with 20 points on it to look at each worker's situation carefully, taking each factor into account individually
The Essence of the 20-Factor Test
The 20-factor test was a tool used by the IRS to assess the nature of the relationship between a worker and a business. It focuses on the degree of control and independence in this relationship. The test encompasses a wide range of aspects, from work schedules to the method of payment, each contributing to a comprehensive view of the working arrangement.
Before we break down the test, it's important to note that the IRS no longer uses this specific 20-question test to determine worker status, but it might help you to understand the details of what is being evaluated under the three key category test that utilizes the 20 factors.
Key Factors and Their Implications
InstructionsWorkers are generally told where, when, and how to work. For instance, a worker in an office may be required to work from 9 AM to 5 PM at the company's location, using specific methods for completing tasks. Independent Contractors generally do not have a set schedule and work on a deadline at a location of their choosing.
TrainingWorkers may receive training from a company, which indicates the company wants the work done in a specific manner. As an example, a new worker at a coffee shop receives training on how to make drinks according to the shop's recipes and standards. Independent Contractors are trusted to use their expertise to complete assignments in their own method and manner.
IntegrationWorker's services are usually integrated into business operations, showing that they are subject to a company’s direction and control. Let’s say a graphic designer's work is integral to an advertising agency’s business, collaborating closely with the agency's team on projects, then they’re most likely a W2 worker rather than independent contractor.
Services Rendered PersonallyWorkers must render their services personally; Independent Contractors have the freedom to hire additional help for their projects without approval from their clients.
Hiring AssistantsIf the company hires, supervises, and pays workers' assistants, this is seen as company control, like a construction company hires and pays for laborers to assist a site supervisor, a worker at the construction company. Independent contractors are free to hire assistants, but they must pay their wages themselves and budget the fee accordingly for the contract.
Continuing RelationshipA continuing relationship between the worker and the company suggests worker's status. For instance, a receptionist works at the same company for several years, indicating a long-term employment relationship. Independent Contractors often take shorter projects, some lasting only a few days or weeks.
Set Hours of WorkWorkers usually have set work hours. An example might be, customer service representative is scheduled to work specific shifts, such as 8 AM to 4 PM, set by the company. Independent Contractors work on a deadline, so they are generally welcome to work any hours they choose so long as the deadline is met.
Full-Time WorkFull-time work suggests control by the company. An accountant works 40 hours a week for a firm, reflecting full-time employment status. Independent Contractors have the freedom to work for multiple clients at once, and thus, do not work full-time for an individual client.
Work Done on PremisesIf work is performed on the company's premises, this indicates control over the worker. A factory worker performs all their duties within the factory premises, under the supervision of the factory management. Independent Contractors are welcome to work from their own offices, or other location of their choosing, and do not require the level of supervision that necessitates them being onsite.
Order or Sequence SetIf a company sets the order or sequence of work, this indicates control. An example might be a supervisor tells a warehouse worker the specific order in which to arrange products, demonstrating control over work tasks. Independent Contractors use their specific expertise to set the sequence of work at their professional discretion.
ReportsRegularly required oral or written reports indicate control. Think of a salesperson being required to submit weekly reports to their manager detailing their client interactions and sales. Independent Contractors may provide updates on their deliverables, but not on a regular cadence, and to a point of contact rather than a manager or supervisor.
Payment MethodWorkers are typically paid by the hour, week, or month. As evidence a retail store worker is paid weekly at an hourly rate. Independent Contractors are paid by project or based on deliverables.
Payment of Business and/or Travel ExpensesCompanies often pay worker's business and travel expenses. Another example is a company reimburses a worker for travel expenses incurred during a business trip. Independent Contractors are expected to take into account any travel or extraneous expenses and factor that into their fees; they pay for travel and expenses themselves.
Furnishing Tools and MaterialsWorkers are usually provided with the necessary tools and materials by their company. For example, an auto repair shop provides mechanics with all the necessary tools and parts needed for vehicle repairs. Independent Contractors provide their own tools needed to complete the project.
Significant InvestmentIndependent contractors often have a significant investment in their work. An independent consultant purchases their own computer and software to conduct their business. It is also common for Independent Contractors to rent office space, hire their own employees, and obtain the appropriate licenses and insurance.
Profit or Loss RealizationIndependent contractors can realize a profit or loss. A freelance web developer bears the risk of profit or loss based on their management of projects and expenses. Workers do not risk profit loss as their expenses are paid by the company. Even if a worker mismanages the budget, the company takes the financial hit.
Working for More Than One Firm at a TimeThis factor suggests independent contractor status. Think of a graphic designer working on projects for several different clients simultaneously.
Making Services Available to the General PublicIndependent contractors generally make their services available to the public. Think of a plumber who advertises their services to the general public and takes on jobs from various customers. Workers provide their services only for their company.
Right to DischargeThe ability to discharge a worker suggests they are a W2 worker. A store manager can fire a cashier for not following company policies. As Independent Contractors are not workers, they cannot be discharged for their performance, except as outlined in the contract for their services.
Right to TerminateIf the worker can terminate the relationship without incurring liability, this suggests worker status. A worker can quit their job without facing any contractual penalties from the company. An Independent contractor cannot terminate the business relationship with their client, except in accordance with the contract for their services.
The current IRS system for determining a worker's classification evolved from this test, refining the criteria into three distinct areas for a more streamlined and effective assessment process, outlined below:
The New Way: From 20 Factors to Three Key Categories
While the IRS no longer uses the 20 factors, it has evolved, consolidating the factors into three primary categories to facilitate a more focused review of each specific case:
Behavioral ControlThis examines the degree of instruction and training an individual receives and how much control the company has over the execution of their work. The aspects of the 20 factors that help determine classification in this category are training, set working hours, and having to follow company policy.
Financial ControlThis aspect looks into the business aspects of an individual's job, like how they are paid, whether they can realize a profit or loss, and their level of investment in the equipment they use. A few of the 20 factors that determine classification in this category are profit or loss realization, payment of business and travel expenses, and the significance of the individual’s investment.
Relationship of the PartiesThis category considers how the individual and company perceive their interaction, including the presence of contracts, benefits, and the permanency of the relationship. Factors that assist in determining the appropriate classification for this category include the ability to work for more than one firm at a time and the contractor making their services available to the general public.
It's crucial to note that the IRS starts with the presumption that a worker has W2 status, unless it can be conclusively proven otherwise. Consequently, the burden of proof falls on the company to justify their classification of an individual as an independent contractor.
When assessing these factors, it's important to understand that the IRS doesn't weigh any single factor exclusively. While there isn't a definitive "magic number" of factors determining an individual's status, sometimes just one significant factor might prompt the IRS to classify an individual as a worker.
This nuanced approach underscores the importance for companies to carefully consider and document their workers' roles to ensure accurate classification and compliance with tax regulations. Otherwise, fines can be levied against the company if the government determines workers have been misclassified.
How To Protect Yourself
Understanding and adhering to the IRS's guidelines is crucial for any business. The distinction between an independent contractor and a W2 worker affects everything from tax obligations to worker benefits and legal implications. The IRS test is used in Arkansas, Indiana, Missouri, Ohio, Rhode Island, Tennessee, and Virginia. Elsewhere in the US and across the globe, other factors are used to determine the appropriate classification, and they vary drastically. This is where TCWGlobal stands as an invaluable partner, offering expertise and solutions to navigate these intricate waters.
Expertise in Classification
TCWGlobal understands the nuances of not only the IRS’s evolved system of Independent Contractor classification but also the intricacies of individual state and country regulations. By leveraging our expertise, your business can confidently classify workers, ensuring compliance with the latest tax laws and employment regulations. This is particularly crucial given the IRS's presumption that an individual is a worker unless proven otherwise, placing the burden of proof squarely on the company.
Every business is unique, and so are its employment needs. TCWGlobal Employer of Record Services offers tailored consultation services, helping businesses analyze each worker's role against the specific state, country, or the IRS's three primary categories of classification: behavioral control, financial control, and the relationship of the parties. This bespoke approach ensures that each classification decision is well-informed through a thorough individualized assessment and fits your specific business context.
Documentation and Compliance
Accurate documentation is key in demonstrating compliance with employment classifications. TCWGlobal assists businesses in providing personalization assessments and maintaining thorough and precise records, detailing the nature of work, payment methods, and the degree of control exercised over each worker. This meticulous approach is a critical defense against potential audits and fines for misclassification.
The consequences of misclassifying workers can be severe, ranging from legal challenges to severe financial penalties. TCWGlobal's expertise helps mitigate these risks by ensuring that your classifications align with state, country, and IRS guidelines. Our proactive approach to identifying potential red flags or areas of concern can save your business from costly legal entanglements, substantial fines, and reputational damage.
The complexity of distinguishing between an independent contractor and a W2 worker requires careful attention and expert guidance. TCWGlobal stands ready to assist your business in navigating these challenges, ensuring legal compliance, and protecting you from the ever-increasing risks of misclassification. Our comprehensive approach and deep understanding of the state, country, and the IRS’s criteria make us an indispensable ally in managing your workforce effectively and legally. Keep an eye out for further guides on additional state and country independent contractor regulations! Should you need additional information in the meantime, please do not hesitate to contact us at firstname.lastname@example.org.