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Independent Contractor vs. Employee Determination

By MICHELE D. SLOCUM, CPA

February 18, 2021

Many business owners are perplexed by determining whether an individual is acting as an employee or independent contractor. The determination is challenging because there are often confusing federal and state guidelines and because it seems they change regularly. Many are surprised to learn that although an individual may appear to be working in an independent contractor’s role, they are considered an employee by the IRS and state law.

How an individual is classified is important when calculating employment taxes. Businesses that use independent contractors generally have no employment tax payment requirements, while those with employees do. When a misclassification occurs, the employer is typically required to pay the missed employment taxes.

To help clients, prospects, and others in the determination process, Klatzkin has summarized the key considerations below.

IRS Guidance
For federal employment tax purposes, an individual is considered an independent contractor if the company has the right to control and direct the work results, but not how and when it will be completed. When determining status, the IRS encourages businesses to consider the following.

  • Behavioral Control – An individual is considered an employee when the business directs and controls the work performed, even if the right is not exercised. Employers should carefully review the type of instruction given. For example, instructions given on where and when to work are indicative of an employee relationship. Also, evaluation systems measuring how work was completed are also indicative of the same status.
  • Financial Control – Does the business have a right to control a job’s financial and business aspects? In answering this question, clues will arise that point to an individual’s status. For example, the opportunity for profit or loss is generally taken by an independent contractor and not an employee. Suppose payment is provided on a recurring and ongoing basis. In that case, the individual is likely an employee, whereas when payment is made only upon job completion, they would be considered an independent contractor.
  • Relationship – How do the individual and business perceive interactions with one another? For example, if an individual is provided benefits such as insurance, vacation, or sick pay, they are considered an employee. Another critical point is the permanency of the relationship. If there is an expectation the relationship will continue indefinitely, rather than terminate at the end of the project, they are an employee.

These rules are broad guidelines that businesses can use to determine classification. However, equally as important are the individual circumstances to each situation that could necessitate one classification versus the other.

New Jersey Independent Contractor Test

When determining classification for state employment tax purposes, New Jersey relies on the “ABC” test. According to regulations, it should be assumed an individual is an employee unless all of the following conditions are met:

  1. The individual has been and will be free from control or direction over the performance of work, both under contract and in daily application; and
  2. The work is either outside the usual course of business for which such service is performed, or the work is performed outside of all places of business for which the service is performed; and
  3. The individual must be customarily engaged in an independently established trade, occupation, profession, or business.

In many cases, it is difficult for an employer to determine the status of an individual providing services. Since there can be significant tax issues for non-compliance, the state offers employers access to the Worker Classification Questionnaire used by auditors and investigators making an evaluation.

Pennsylvania Independent Contractor Test

When determining classification for state employment tax purposes, Pennsylvania relies on a modified version of the ABC test outlined above. The state assumes all individuals are employees unless both of the following conditions are met.

  • The individual has been and will continue to be free from control or direction over the performance of the services includes, both under contract and in daily application, and
  • The individual must be customarily engaged in an independently established trade, occupation, profession, or business.

If an individual works in the construction industry, then they must meet all of the following criteria to be classified as an independent contractor, including:

  • The individual has a written contract to perform services.
  • The individual is free from control or direction over the performance of the services involved.
  • The individual is regularly engaged in an independently established trade, occupation, profession, or business.

It is important to note that the written contract must be specific to the project for which the individual will be performing services.

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The issue of worker classification is one that seems to be constantly changing. However, these guidelines should provide a clear idea of an individual’s status for employment tax purposes. If you have questions about the information outlined above or need assistance with a federal or state tax issue, Klatzkin can help. For additional information, click here to contact us. We look forward to speaking with you soon.

©2021 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date and does not constitute accounting, tax, or financial advice. Please consult your advisor concerning your specific situation.

About the Author

Michele is a Manager focused on serving the tax planning, reporting, and compliance needs of real estate, professional service and nonprofit organizations. She enjoys working to find tax-saving opportunities, many created through tax reform, including Section 199A deductions, bonus depreciation and capital gains deferral through investment in Qualified Opportunity Zones.    Going beyond the expected...

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