Unlike independent contractors, employees are entitled to many benefits such as worker’s compensation funds, unemployment insurance, anti-discriminatory laws, protection against wage deductions, annual paid leaves, and the right to be a part of labor unions.
Such benefits and perks come at a substantial cost to the employer. Thus, employers often avoid such costs by hiring independent contractors or misclassifying employees as freelancers. However, misclassifying employees or freelancers might lead to legal troubles for organizations.
Hence, employers must understand the rules for employee classification. After all, classifying an individual as an independent contractor or employee is one of the most contested topics in employment law.
The IRS 20-Factor Test is a popular check system used by the IRS (Internal Revenue System) for assessing employee misclassification by companies. Let us look at this in detail.
The employer must withhold income taxes of their employees, pay taxes for their social security and medicare, and unemployment taxes levied on their salaries. This is an obligation only for an organization's employees and not for independent contractors or freelancers.
Sometimes employers wrongly classify their employees as independent contractors to avoid the burden of payroll and taxes. Such misclassification of employees is considered a deliberate attempt to avoid taxes and withhold the law-mandated protection and benefits from employees.
The IRS has developed a checklist to determine workers' status. It's the “Right-to-control” test. It evaluates employees' independence and control in their workspace and the employer-employee relationship. The IRS 20-factor test seeks to identify a presence of control in the employee-employer relationship.
An organization dictates its employees' job responsibilities, time, and workplace. However, they have minimal control over the time and place of work for individual contractors or freelancers.
Thus, the IRS 20-factor test or the IRS independent contractor test helps assess if a company has correctly classified their employees and freelancers/independent contractors and has not falsely misclassified them to avoid taxes. Although employers may save money in the short run by misclassifying their employees, they might face hefty penalties or fines in the long haul.
A professional providing their services to employers on a need or project basis is an independent contractor or freelancer. They outline the basis of the services, service charges, availability, etc., based on the employer’s requirements. Essentially, hiring companies do not have direct control over an independent contractor’s performance, place of work, or working hours. However, when compared to employees, independent contractors hold significant control of their work.
They receive payments (hourly or fixed charges) as agreed upon under the work contract with the employer/client. While independent contractors do not receive perks like employees (social security, medicare, pensions, etc.), employers can offer them adequate bonuses if they exceed expectations.
Since independent contractors fall under self-employed personnel, they must file their self-employment taxes. Their clients/employers cannot withhold independent contractors' federal, state, or local taxes.
The IRS uses common-law principles for determining if a professional is an employee or an independent contractor. Common laws derive from previous decisions taken by the court. They are generally used when making a decision based on the current law or regulations. The IRS uses common laws to determine a worker’s status for federal employment tax purposes.
The IRS-20 factor test is also beneficial in evaluating a professional’s status. We now have the IRS 20-point checklist for independent contractors to make this evaluation easy, broken down into behavioral, financial, and the relationship between two parties.
Note: IRS considers a professional an employee by default unless proven otherwise. This is why it is vital to classify employees correctly.
The IRS 20-point checklist for independent contractors helps determine the relationship between the worker and the hiring party. However, you must regard these factors as guidelines - you must remember that all factors do not apply to every situation. Sometimes, even one factor is sufficient to establish the relationship between the employer and employee.
The parameters of the employee vs. independent contractor 20-factor test of IRS are -
Apart from the IRS 20-factor test, there are many other tests for determining employee classification, such as Economic Realities Test and ABC Test.
In the ABC test, professionals are classified as independent contractors only if they are free from the direction and control of the hiring partner, they are engaged in other work beyond the hiring organization’s standard business, and they generally engage in a trade/occupation that is similar to the work they perform for the hiring party.
The Economic Realities Test determines a professional’s dependence on the hiring company. It evaluates five factors:
The IRS 20-factor test establishes the control and independence a professional exercises in the work offered by the hiring party. Thus, the IRS 20-point checklist for independent contractors aims to determine the scope of control to declare an individual as an employee or an independent contractor.
Businesses must be extra cautious when classifying their recruits because incorrect classification may attract hefty penalties and fines. This becomes even more crucial for foreign companies expanding overseas and hiring foreign employees. Hence, hiring a global employer of record (EOR) service provider like Multiplier would be wise.
Multiplier assists global companies in establishing their brand in a foreign land. Multiplier provides other services like employee onboarding, payroll management, drafting employment contracts, etc. Services provided by Multiplier help the companies in ensuring compliance with the labor laws of the foreign countries and ease in creating global teams.
What would happen if the company is found deliberately misclassifying the workers?
If a company is found guilty of misclassifying the workers for avoiding withholding taxes, it would be penalized by a court of law.
How can international companies avoid the misclassification of the penalties?
Companies that do not have much knowledge about the international hiring systems should hire EOR service providers who can handle compliance issues and guide them on how to classify workers correctly.
What does the IRS 20-factor checklist check?
The IRS 20-factor checklist determines the control of the hiring company on a professional’s work performance, working hours, job location, etc.