Lands on Schedule C, line 11 — Contract labor, if the worker really is a contractor

If you are the worker, and a 1099 or a job offer has you wondering what that makes you, this article is written from the other side of the desk: start with what a "1099 employee" really is. It is not for the workers whose status a statute fixes rather than these tests, the statutory employees and statutory nonemployees, of whom direct sellers are the best known. And it does not cover the tests some states apply under their own law.

It is for the business that pays someone for services and has to decide, before the first payment, which of the two it is paying. The IRS puts that decision on you: "It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors."

The short answer

One question sits under all the others: does the business have the right to control how the work is done, or only the result? The IRS sorts the evidence into three categories and weighs them together.

Points to an employee Points to an independent contractor
Told when, where and how to do the work Told what result to deliver, and left to get there
Trained in the business's own methods Uses their own methods
Paid a regular wage by the hour, week or month Paid a flat fee for the job
Expenses reimbursed, tools supplied Carries their own costs, and can make a loss
Hired with no end date in view Hired for a project or a period
Does the work the business itself sells Offers the same service to others

No single row settles it. The IRS: "There is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor and no one factor stands alone in making this determination."

Behavioral control: the right, not the practice

The first category asks whether there is "a right to direct or control how the worker does the work." The word that matters is right. "The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work." A manager who never gives an instruction has not turned an employee into a contractor.

The instructions that show control are ordinary ones: when and where to work, what tools or equipment to use, who to hire to help, where to buy supplies, what work a named person must do, and in what order. The more detailed they are, the stronger the evidence. Training weighs heavily. Being taught how to do the job "is strong evidence that the worker is an employee," and periodic training in procedures and methods "is even stronger evidence of an employer-employee relationship." An evaluation that measures how the work was done points to an employee; one that measures only the end result can point either way.

A business that could not tell a specialist how to do the work can still hold the right. The question is "whether the business has retained the right to control the details of a worker's performance or instead has given up that right."

Financial control: who carries the money risk

The second category asks whether the business controls "the economic aspects of the worker's job." Five things are looked at: a significant investment in equipment, unreimbursed expenses, the chance of a profit or a loss, whether the worker offers services to the market, and how the worker is paid.

Two cautions keep this from becoming a checklist. Investment is not decisive either way: "in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees," while some contractors need almost no equipment at all. And the method of payment bends by trade. A flat fee for the job is usual for a contractor, but "it is common in some professions, such as law, to pay independent contractors hourly."

One factor reads almost as a definition of being in business: "Having the possibility of incurring a loss indicates that the worker is an independent contractor." A worker whose fixed costs run whether or not there is work that month, and who can end a job poorer than they started it, is carrying a risk no employee carries.

The relationship, and why the contract counts for so little

The third category is how the two sides see the arrangement: the written agreement, employee-type benefits such as paid vacation and sick days, whether the relationship is meant to last, and whether the work is a key activity of the business.

The agreement is the evidence a business has in writing, and the IRS gives it little room:

"Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker's status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self-employment tax. How the parties work together determines whether the worker is an employee or an independent contractor."

The other three facts carry more. Hiring someone "with the expectation that the relationship will continue indefinitely, rather than for a specific project or period," is evidence of employment. Work that is a key activity of the business points the same way; the IRS's example is a law firm that hires an attorney, which "will present the attorney's work as its own and would have the right to control or direct that work." Benefits cut one way only: granting them suggests an employee, but their absence "does not necessarily mean the worker is an independent contractor."

What a wrong call costs the business

The two answers lead to different obligations. For an employee, "you must withhold and deposit income taxes, Social Security taxes and Medicare taxes from the wages paid," pay "the matching employer portion of Social Security and Medicare taxes," and pay unemployment tax on the wages. For a contractor: "Generally, you do not have to withhold or pay any taxes on payments to independent contractors." The paperwork follows. An employee gets a Form W-2. A contractor gives you a Form W-9 before the first payment and gets a Form 1099-NEC once you have paid them $2,000 or more in the year.

Call an employee a contractor and the gap lands on the business: "If you classify an employee as an independent contractor and you have no reasonable basis for doing so, then you may be held liable for employment taxes for that worker."

The relief the IRS means, for a business that did have a reasonable basis, is known as section 530, after the 1978 Act that created it. It has three conditions, all of which must hold:

  • Reporting consistency. You filed on time every information return your treatment of the worker required: for someone you call a contractor, the Forms 1099 for each year in question.
  • Substantive consistency. Neither you nor a predecessor treated that worker, or anyone in a substantially similar position, as an employee at any time after 1977.
  • Reasonable basis. When you made the decision, you relied on a prior IRS audit, on judicial precedent, on industry practice, or on some other reasonable basis. A reason found later does not count: "The statute does not allow ex post facto justification."

Two limits come with it. The relief "does not determine a worker to be an independent contractor"; it protects the business "regardless of the proper classification of the workers." And it does not reach the worker, who can still be found to be an employee and then report the employee's share of Social Security and Medicare on Form 8919. The practical point sits in the first condition. The 1099-NEC forms a business files each January are part of its defense, and one that skipped them has lost the relief before anyone asks who controlled the work.

Getting a decision, or changing course

Form SS-8. When the facts do not settle it, or you hire the same kind of worker again and again, you can ask the IRS. Either side may file, and the IRS "will review the facts and circumstances and officially determine the worker's status." Allow for "at least six months."

The Voluntary Classification Settlement Program. A business that has treated workers as contractors and now thinks they are employees can change course for the future with partial relief. It must have treated them consistently as nonemployees, "including having filed all required Forms 1099 for the workers to be reclassified under the VCSP for the previous three years", and must not be under an employment tax audit, or an audit of those workers' classification by the Department of Labor or a state agency. In return for treating them as employees from then on, it pays 10% of the employment tax that would have been due for the most recent tax year, figured at the reduced rates of section 3509(a). It owes no interest or penalties on that amount, and faces no employment tax audit of those workers' classification for earlier years. The application is Form 8952, filed at least 120 days before the date the change is meant to start.

Write the decision down

The IRS ends its own guidance with an instruction: "Finally, document each of the factors used in coming up with the determination." A note made when the worker is taken on, saying what you control and what you do not, how you pay, what they bring and how long the work should last, is the evidence any later review will ask for. It is also how you show that a reasonable basis existed when the decision was made, which is the only time section 530 counts it. Keep the worker's Form W-9 with it; the IRS says the W-9 "should be kept in your files for four years."

Common questions

Is a signed independent contractor agreement enough?
No. The IRS: "Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker's status." The agreement is evidence of the relationship the two of you intended, weighed with everything else.
If I pay by the job, is the worker a contractor?
It points that way, and no further. The IRS says an independent contractor "is usually paid by a flat fee for the job", while a regular hourly, weekly or other periodic wage usually indicates an employee. It adds that in some professions, such as law, independent contractors are commonly paid by the hour. No single factor decides the question.
Can someone who works from home be my employee?
Yes. The IRS: a remote worker "is your employee under the common-law rules, if you can control what will be done and how it will be done. This is so even if the worker can choose to work remotely."
Who can ask the IRS to decide?
Either side. Form SS-8 "may be filed by either the business or the worker", and the IRS then reviews the facts and determines the status officially. It warns that "it may take at least six months to receive a determination."
I have been paying employees as contractors. Can I put it right from now on?
Possibly, through the Voluntary Classification Settlement Program. An eligible business agrees to treat the workers as employees from then on and pays 10% of the employment tax liability for the most recent tax year, figured at reduced rates, with no interest or penalties on that amount. It applies on Form 8952, at least 120 days before the date it wants to start.

This article is for educational purposes only and does not constitute tax, legal, or financial advice. Consult a qualified tax professional about your situation.

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