A. Employee Versus Independent Contractor Status

The IRS generally opposes independent status because companies who retain independents don't have to withhold income or employment taxes. Since a contractor can manipulate earnings by claiming all business-related expenses on Schedule C (where expenses offset gross business income), the IRS believes that many dollars of compensation go unreported. Additionally, if you are an independent contractor who is injured while working, you are not bound to collecting workers' compensation damages for your injuries. This is advantageous since larger awards typically go to claimants who commence private lawsuits for injuries than workers' compensation benefits.

As an independent contractor, however, you are not permitted to file for unemployment benefits after a job has ended or you are terminated unless it is determined at the unemployment hearing that you are legally an employee. You probably cannot avail yourself of employer-provided disability and health insurance plans, and may have to establish your own retirement and pension plans. Since you will receive an IRS Form 1099 and not a W-2 form with deductions withheld, you are responsible to pay all applicable social security, unemployment insurance, state and local income taxes, and workers' compensation insurance benefits for any people you employ. Under the laws of many states, you probably will have a more difficult time asserting discrimination claims. Furthermore, you cannot assert claims for overtime since wage and hour laws apply only to employees. (Note: In a recent ruling however, the 9th U.S. Circuit Court of Appeals rejected Microsoft's attempt to withhold benefits from workers it said were freelancers rather than employees. The Court stated that the practice of hiring temporary employees or independent contractors as a means of avoiding payment of certain employee benefits was troubling. Microsoft has appealed the decision.)

No precise legal definition of an independent contractor exists, and each state has its own laws to determine whether an individual is an employee or an independent contractor. When the courts attempt to determine the difference, they analyze the facts of each particular case. Significant factors courts look for when making this distinction are:

1.The company's right of control over the worker;

2.Whether the individual works exclusively for the company or is permitted to work for others at the same time;

3.Whether the parties have a written agreement that defines the status of the worker and states she is not considered an employee for the purposes of the Federal Contributions Act and the Federal Unemployment Tax Act and that the individual must pay all self-employment and federal income tax;

4.Whether the individual controls her own work schedule and the number of working hours; and

5.Operates from her own place of business (or pays rent if an office is provided) and supplies her own stationery and business cards not at the company's expense.

Typically, employees undertake to achieve an agreed result and to accept an employer's directions as to the manner in which the result is accomplished, while independent contractors agree to achieve a certain result but are not subject to the orders of the employer as to the means that were used. In each case, the court looks at the specific facts in making its determination. For instructive purposes, the company's right of control is best explained by the use of examples. Courts have found workers to be employees if companies:

• have the right to supervise details of the operation
• require salespeople to collect accounts on its behalf
• provide workers with an office, company equipment, company car, and/or reimbursement for some or all expenses
• require workers to call on particular customers
• deduct income and FICA taxes from their wages or salary
• provide workers with insurance and workers' compensation benefits
• restrict their ability to work for other companies or jobs and require full-time efforts

This list is not meant to be all-inclusive, but rather to help you determine what classification you fall under. Since the law is quite unsettled, the IRS follows a summary of rules used to determine proper status. According to the IRS, an employer-employee relationship for tax purposes exists when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which the result is accomplished. In this connection it is not necessary that the employer actually direct or control the manner in which services are performed; it is sufficient if the firm had the right to do so. The designation or description of the relationship of the parties in a written agreement other than that of an employer and employee is immaterial if such a relationship exists, and the IRS will disregard other designations (such as being called a partner, agent, consultant or independent contractor) in the agreement.

On page 31 you will find a summary of rules used by the IRS to determine proper status. Courts do consider other relevant facts and circumstances not contained in the list and may overrule initial IRS and state tax determinations where warranted.

Tip:The odds of finding employee status become lower when you form a corporation and receive compensation from your corporation. The IRS may also be impressed when your corporation works for several companies and not just one.

When an initial determination is made by the IRS finding employee status, costly damages, penalties, and interest can ensue to you and the company hiring you. Speak to a competent lawyer or accountant immediately upon receiving an initial IRS or state taxing agency notice of determination or request for facts. Competent tax advice and guidance is crucial in this area.