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Warning: Contractors must really be independent!

Our challenge is getting more difficult

How many of us have “hired” independent contractors over the years, a bit worried over the gray area between employee and contractor as defined by the IRS?  Or separately the State of California?  I’ve experienced the results of a wrong decision, and the IRS and state agencies are not forgiving in their pursuit of penalties, interest and most damaging, assessing a company with the on both employer and employee taxes when reclassifying the person as an employee.

IRS penalties for getting it wrong

Yes, that’s right. The company must pay the employee’s portion of the taxes (and penalties on these) as well as paying those they would have paid if the person were an employee.  That’s even more serious for today’s gig workers in California being attacked by the government requiring them to be reclassified as employees.

The newest IRS test

And the IRS has raised the bar on its test as to whether an independent contractor is not in reality an employee.   So, it is important – no really it is urgent – that we review some of the twenty – yes twenty – tests the IRS now uses to determine if a person is an independent contractor.

Here are the ten IRS tests

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  1. Contract for service: An independent contractor should work under a written contract with the company, defining the end result expected, time to achieve, lump sum or unit cost, ownership of intellectual property created and more.
  2. Direction: The contractor directs itself, rather than being managed as an employee. And just as important, a contractor does not supervise any of the company’s employees directly. This is tricky when a contracted CFO assumes a position of directing an accounting department.  Usually, in acceptable cases such as this, the contracted executive comes from a recognized agency with a history of paying its own employee taxes, health insurance, and other benefits.   Without this protection, a contracted executive is suspect, even if working with more than one company at a time.
  3. Integration: A contractor provides services which are not an integral part of the core business of the employer. This one is tricky. Is a contracted CFO an employee because the CFO job is integral?   How about a contractor CEO?   The person must pass all the other tests when one of them, such as this, crossed into the very gray zone.
  4. Individual on the job: A contractor may hire a substitute without the company’s permission – although the company should then be able to terminate the contract with the contractor if the substitute is not acceptable.
  5. Term: A contractor is hired for a specific project, usually tied to a time term. An undefined period of time favors the ruling as employee.
  6. Reporting: Here is a surprise. The IRS wants to test that a contractor is NOT required to submit regular reports. Yet, most of us would want to have such documentation of progress other than an invoice.
  7. Tools and materials: The contractor must supply his or her own tools. This is tricky when a contractor sits at your desk using your computer and your phone system all day.
  8. Physical facility: The contractor must have its own “home office” even if in a bedroom, from which primary work is performed.
  9. Works for more than one company: If such a person works only for a single company for any period of time, that person will probably be determined to be an employee. A contractor must make services available to the general public.
  10. Termination: A contractor works under a contract – which means that an independent contractor cannot be “fired,” as long as results are satisfactory as defined within the contract of service.

California’s “ABC Test” for gig employees

In California, there are still suits pending as of this writing as to whether app-based gig employees (think Door Dash, Lyft, Uber and many more) are really employees.  The state developed an “ABC Test” which has passed a State Supreme Court challenge:

A: Companies must prove they don’t control the work performed. Gig employers don’t want to look like they control their contractors. An example is Uber where the Company does not want to look like it controls driver schedules.

B: The killer. The contractor cannot work for the core concept of the business.  Uber drivers state that they are doing just that, while the Company claims it is just a platform connecting drivers to riders.

C:  The contractor must establish an independent business.  That is hard for a Lyft driver who works only as a driver for that one company, or even one working for Uber and Lyft as some do.  This is one of the challenges courts will sort out.

Some ways around this for companies

There are more tests, but these are the ones most often used by the IRS.  States add a few of their own; so, beware.   Pay contractors using account payable systems, not payroll services.  Pay only upon receipt of invoices, not with regularly triggered checks or transfers of uniform amounts without invoice documents to back up the payments.

Small companies want to cut cash drains

Many small or early stage company CEOs look for opportunities to cut cash drains, knowing that payroll is usually the greatest cash drain of all. The temptation to reduce that by fourteen percent or more by classifying a gray area employee as a contractor is very high.  And that includes self-payments to a founder.

How about founders?

Founders working for a company are employees if they take regular payments, subscribe to company benefits, attend regular company meetings, or fail any of the tests above.  The temptation to just draw cash and call it a loan or document a year’s withdrawals with a 1099 is great, but highly risky.

The danger of an IRS tax bill reaching back years

There is nothing worse than a large tax bill and threats of a government agency seizing a cash account when a company cannot or does not respond with proper documentation or payment.  And even a single year’s worth of transgressions, when added into a single tax bill with penalties and interest, can appear daunting to small and young companies.

Management discipline and liability

Like payment of payroll taxes by incremental impound each pay period, as opposed to waiting until the last minute and making manual tax payments, it is a proper discipline of management to “take the hit” incrementally to protect the business from a catastrophic failure to pay a governmental agency any form of tax when and as due.   Need we emphasize the personal liability of management AND the board of directors attached to tax payments?

Good management takes discipline and enough knowledge to prevent these possibly crippling errors in judgment that stem from decisions made to avoid or put off tax payments when accrued or due.


  • William L. Pope

    Shane and Dave–those occupations on the so-called AB 5 exemption list are still subject to the Borello test: S. G. Borello & Sons, Inc. v Dept. of Industrial Relations (1989) 48 Cal.3d 341. This test has 11 items to consider when determining if a worker on the exemption list still qualifies as an independent contractor. This test is a bit more flexible than AB 5, but the overriding principle still applies–the worker must truly be independent; just being on the list does not automatically qualify the person as an independent contractor. This is separate from the Fed’s tests, as Dave stated.

  • Shane,

    Unfortunately, there is no connection between the laws “rules” in California and the Federal IRS guidelines. Many times in the past, and now too, these have diverged. Your California exemption does not affect the ten tests the Fed’s apply above.


  • Shane Paquette

    In CA our industry was added to the exempt list of AB5. Since it’s legal in CA for our industry to have IC’s, how does this effect the view of the IRS when it comes to federal regulations?

  • Bob,
    The IRS penalties always fall upon the company, not the contractor. Unfair? Sure. But the company made the decision to classify the person as a contractor in the eyes of the IRS, and is easier to reach. Ouch.
    – Dave

  • Bob Wallach

    Are the IRS penalties you mention in this article a risk to the company, to the contractor or both?

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