Many businesses prefer to hire independent contractors, to simplify their payroll and to avoid expenses associated with employee withholdings. 

But these businesses should be aware that the Internal Revenue Service (IRS) and the Oregon Department of Revenue (ODR) each have their own set of criteria for distinguishing employees from subcontractors. Both agencies look to their own guidelines – not your designation – to determine whether a worker is an employee or a subcontractor.

Knowing the difference between an employee and a subcontractor can save you an unpleasant and very expensive visit by the IRS or ODR. If your business is audited and has wrongly classified an employee as a subcontractor, the taxing authority will reclassify that worker and assess the taxes you should have withheld and paid. In addition, you likely will be assessed substantial penalties and interest.

In some cases, the amount assessed can be overwhelming. If your business cannot pay the tax, you may be personally assessed the withholding portion as a civil penalty.

The IRS has published a set of 20 criteria to help distinguish employees from independent contractors. If you are considering hiring someone as an independent contractor, you should be familiar with these guidelines plus ODR’s guidelines (this article addresses only the IRS’ criteria).

The primary issue is the extent to which you have control over the worker. The more control you exercise, the more likely the worker is to be an employee. I have condensed the 20-point IRS guidelines as follows:

1. A worker who is required to comply with instructions about when, where and how he or she is to work is ordinarily an employee. Even if your business doesn’t give instructions, the worker is considered an employee if the business has the right to require compliance with instructions.

2. If you provide training to the worker, this indicates an employee-employer relationship.

3. If the worker’s activities are integrated into the flow of work performed by employees at the business, it is likely the worker is an employee.

4. If the worker must perform the required services personally, as opposed to having the ability to substitute in other people to perform the service, it is more likely the worker is an employee. (This is exclusive of people with specialized talents, such as performing artists.)

5. Independent contractor status is more likely if the worker hires, supervises and pays his or her assistants, especially if the worker is responsible only for the results obtained and not the methods employed.

6. A continuing (ongoing) relationship is more likely to indicate an employer-employee relationship.

7. If your business sets the worker’s days and hours of work, this indicates an employer-employee relationship.

8. If the worker is required to work full-time or nearly full-time, this likely indicates an employer-employee relationship.

9. An employee-employer relationship is more likely if the worker must perform the work on the premises, especially if the work could be performed elsewhere.

10. If the worker must follow a set pattern or sequence as set by your business, an employee-employer relationship is more likely.

11. If the worker must submit regular or written reports to you, an employee-employer relationship is more likely.

12. Hourly, weekly or monthly payments make an employee-employer relationship more likely.

13. If the worker’s travel or business expenses are paid by your business, an employee-employer relationship is more likely.

14. If you provide the worker’s tools and materials, an employee-employer relationship is more likely.

15. If the worker invests in his or her own facilities (such as office or shop space), it is more likely the worker is an independent contractor.

16. If the worker can realize a profit or loss as a result of the services provided, it is more likely the worker is an independent contractor.

17. If the worker provides services for multiple and unrelated persons or firms, it is more likely the worker is an independent contractor.

18. If the worker makes his or her services available to the general public, it is more likely the worker is an independent contractor.

19. An employer exercises control by holding the power to terminate an employee. On the other hand, an independent contractor generally cannot be fired as long as the results meet the contract’s specifications.

20. An employee at will has the right to terminate his or her employment without incurring liability. An independent contractor is subject to the terms of a contractual arrangement and may be subject to liability for leaving before completion of a project.

If you hire someone as an independent contractor and are not certain he or she qualifies as such, you might consider professional advice. Your CPA or accountant should be able to provide direction.

The alternative – to wait and see what the IRS or ODR thinks of your business arrangement – may not have a happy ending.

(Donald H. Grim is an attorney at the law firm of Greene & Markley, PC, where his practice focuses on tax determination, tax collection controversies, bankruptcy and estate planning. He can be reached at donald.grim@greenemarkley.com or at 503-295-2668.)