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Consultants, know how the IRS determines employee status

Chip Camden offers independent consultants tips on how to be savvy when it comes to the IRS's 20 factors for determining whether a worker is an employee under common law rules.

 While companies have many legitimate reasons for hiring consultants instead of employees (or vice versa), you might not be aware of one reason organizations might avoid signing on IT consultants: the potential tax liability.

In the United States, if the IRS determines that a consultant's relationship to a client qualifies as an employer-employee relationship, the client will not only have to pay the employer portion of Social Security and Medicare taxes for the period the consultant was engaged (currently 7.65% of qualifying wages), but also penalties and interest. If it's unclear to the IRS whether the consultant paid income taxes on that amount and the consultant can't be reached, the client could also be held responsible for paying those taxes. So in the worst case, it's possible that a client might have to pay nearly half of what they already paid the consultant to the tax man.

In most industries, provisions exist to prevent this kind of catastrophe. So-called "safe harbor" rules seek to insure that as long as your client engaged you as an independent in good faith (and not just to avoid employee status), then they cannot be held liable. In an ill-advised attempt to punish abuses of these provisions by high-tech companies, Congress in 1986 repealed the safe harbor provisions for providers of high-tech services (and only high-tech services). The IRS can punish offenders without warning, whether or not they were previously aware of their non-compliance. Thus, many companies would rather stick with employees to eliminate that risk.

What can independent consultants do about this? We must reassure our clients that they are not vulnerable to a decision by the IRS. IRS Revenue Ruling 87-41 lists 20 factors used to determine whether a worker is an employee under common law rules. You can find some good discussion about these factors on MoreBusiness.com and the UNCSA site; here's my take on the 20 factors.

  1. Instructions. Employers dictate how, where, and when work must be accomplished, while clients express a need that an independent consultant fills in their own way. Consultants know that, in practice, there are a lot of shades of grey here. Clients always have constraints on how they want the job done, and some employers give their employees just as much freedom in choosing implementations as we have.
  2. Training. If the client provides training for you, that demonstrates an employer relationship; to protect against this, you should always acquire your own training. If you really can't afford to obtain the training that your client wants you to have, then you need to creatively structure your billing to cover the costs without making them pay for it directly.
  3. Integration. This is another tricky one. To the degree that the success of your client's business depends on your efforts, the same degree of employer control may be presumed. If your client can't live without you, then you're considered part of their organization. I know that a number of my clients would be vulnerable on that point.
  4. Services rendered personally. If one specific individual must perform the work, then that individual may be considered an employee. That really hits independents hard, because we're usually flying solo. I've even had clients who insisted that our contract explicitly require me to perform all work personally.
  5. Responsibility for assistants. If you need assistance in performing your duties for the client, you should hire those assistants yourself. If the assistants are provided by the client, then you might be considered an employee. This is another one that bites us, because it's generally impossible for us to do our work without significant interaction with the client's employees. This always has to be framed in terms of "requirements gathering" or "user feedback" instead of "assistance."
  6. Continuing relationship. If the engagement does not have a discrete term, or even if the client keeps coming back to you time and again, that could be construed as an employee relationship. Consultants know that long-term clients are our bread and butter. I have several clients with whom I have had engagements of one form or another for more than a decade.
  7. Hours of work. If the client establishes the hours during which you must perform the work, then they are your boss. This requirement is usually easy for independents to meet, because we like to set our own hours; however, I have had clients who insisted that I be available on a regular schedule and that pushes this point a bit.
  8. Full time. If you're required to work for a single client full time, that's waving the red cape in front of the IRS's horns. You should never commit to full time for one client. Not only is it potentially a liability for them, but it's putting all your eggs in their company's basket.
  9. Work on premises. If you're required to perform the work at the client's site, then you could be considered an employee. Software development consultants generally don't have a problem working remotely, but for those who must interact with the hardware, this could get touchy. Just make sure they don't allocate a cubicle or office for you.
  10. Order or sequence. When the client dictates the order of the steps you must take in order to produce a result, that's considered employer control. Again, grey areas abound. What does that say about project milestones? How fine does it have to get to be under their control?
  11. Oral or written reports. The requirement of regular progress reports also indicates control by the employer. Consultants know that regular communication with clients is absolutely essential to success. So you need to make those reports look like your firm is seeking feedback or that these reports are simply part of your deliverables, rather than being required to "check in" by your client.
  12. Payment by the hour, week, or month. Apparently, the IRS considers anything other than fixed price billing an indication of an employer-employee relationship. As I've often stated, I prefer hourly billing. One way in which that can be made to appear more independent is to enumerate the accomplishments of each of those hours in your invoice, like lawyers do.
  13. Expenses. If you cover your own expenses for your business and travel, you're not an employee. I usually insist that clients pick up my travel expenses when I'm traveling on their behalf, but that could be construed as control of business operations by the IRS.
  14. Tools and materials. You should purchase your own equipment, software licenses, and office supplies. If your client pays for those, you could be considered their employee.
  15. Significant investment. Employees generally aren't required to make any investment in the services they provide, while independents who are running their own business must put up some money. Besides office space, equipment, supplies, and advertising, you also have your business licenses, taxes, subscriptions, and membership dues.
  16. Profit or loss. If you're truly independent, then any given engagement could result in a loss due to poor planning or unforeseen circumstances. Employees have no such risk. Again, I try to mitigate my risk of loss by billing by the hour, so if asked, I'd have to creatively frame my potential for lost revenue.
  17. More than one client. Similar to the full-time factor, having only one client indicates an employee relationship. Again, having multiple clients makes good business sense, in addition to being tax savvy.
  18. Publicly available. If you're marketing your services to the general public, that argues for independence. In your quest to obtain new clients, document your expenditures for advertising and promotion.
  19. Right to discharge. Your contract should state that either party may terminate for cause; this means that your client can't just let you go on a whim -- they must honor the contract unless you breach it. That makes you equal business partners, instead of employer/employee.
  20. Right to terminate. The converse is also true. You should be bound by the terms of your contract, not working "at will."

In practice, no single item in the list will make or break the IRS's determination of employee status. If you can make a convincing case for at least several of the factors, your client will probably be okay. If you can make a case for even more factors, it's even better.

Disclaimer: I am not an accountant or a lawyer. If you have specific questions about the IRS ruling discussed in this column, please seek advice from an accountant and/or a lawyer.

Thanks to Chad Perrin, host of TechRepublic's IT Security blog, for the idea for this article.

Get weekly consulting tips in your inbox TechRepublic's IT Consultant newsletter, delivered each Monday, offers tips on how to attract customers, build your business, and increase your technical skills in order to get the job done. Automatically sign up today!

About

Chip Camden has been programming since 1978, and he's still not done. An independent consultant since 1991, Chip specializes in software development tools, languages, and migration to new technology. Besides writing for TechRepublic's IT Consultant b...

15 comments
eternal_life
eternal_life

Yes. this is the only way to succeed, one can not start the discussion on what color of the officefurnishentment which has the "right" outlook this sping, just to menation a very bad example I read in a swedish magazine named chef.se In fact I subscribe to this weird online magazine just to get a hint about what is going on inside the chef/manager head in level of managing.

herterj
herterj

Is there Canadian take on this with the CRA (Canada Revenue Agency)?

manasdas
manasdas

Good advice Chip. I think if you set up a S-Corp, sign Corp-Corp contract with your client and pay yourself salary from your company, you can eliminate many of these risks.

no1kilo
no1kilo

Thank you for this very informative article. Since I am only just now get started as a consultant information like this is highly sought after. Now I have an idea of what I need to watch for.

dmar0001
dmar0001

Good job Chip Camden. Now for your next assignment: how about a recap on the problems and ways to avoid those problems with the IRS, regarding the 12 month limitation on travel expenses("Temp vs. Permanent").

ArnoldZiffle
ArnoldZiffle

I personally have never been questioned by the IRS. It may be that I have had a sprinkling of fulltime employee in my career may make it obvious to the IRS when I'm engaged as an independent contractor. At least so far.

knorup
knorup

Hi Chip, A good overview...while all the factors in total can (and will) ultimately determine the outcome of an IRS determination, two of the most important ones are "direction and control" and "financial risk". In our business we help companies that use contingent workers to be compliant in their worker classifications (which means we validate and document independent contractor compliance, and become the employer-of-record for those who don't qualify), we also work with independent contractors in an agency-of-record model. More information at: www.collabrus.com

Sterling chip Camden
Sterling chip Camden

... had your status with your client questioned by the IRS? What was the result?

Sterling chip Camden
Sterling chip Camden

... I would bet that Glen Ford (aka PMP'sicle) can shed some light here. Glen?

Sterling chip Camden
Sterling chip Camden

... but I've had them ask one of my clients about it. I helped my my client justify our relationship to them.

bboyd
bboyd

Both at the same time, needed to prove that work I did at home was legally contract. ended up being simple to prove my loss and the solution was a nicely worded contract document and good tracking of my expenses in a log. Also got paid per piece produced but that was not the determining factor. Luckily 5 minutes in and out with the auditor. To bad I had mis-calculated how to do my own taxes and had to pay a couple hundred back that year.

Sterling chip Camden
Sterling chip Camden

... can help with the audit, too. Mine even went in my stead, so I didn't have to sweat it in front of the IRS agent.