The IRS 20-Factor Test, Explained

The IRS 20-Factor Test is one of the primary systems the IRS uses to assess whether a worker has been misclassified by the companies that hire them.

Employee misclassification claims put hiring companies at high risk for penalties, fees, and even criminal liability, which is why understanding the rules for classification is so important. But this isn’t as clear cut as you might expect.

The IRS, Department of Labor, and individual state agencies concerned with labor rights use different tests to classify workers. The most common types of tests are the IRS 20-Factor Test, the ABC Test, and the Economic Realities Test.

The problem is these tests lack uniformity. They vary significantly between which factors are considered, as well as the weight given to each factor. As a result, accurately classifying workers can be complex and confusing, even for companies that are trying to work by the book. 

In this post, we’ll cover the IRS 20-Factor Test in full, as well as how it compares to the other common tests.

Understanding the importance of worker classification

According to the Cardozo Law Review, worker classification is one of the most contentious and frequently litigated issues in labor and employment law, and the reason for that is simple. 

Employees are entitled to certain benefits, protections, and rights that self-employed individuals are not, such as health insurance coverage, paid leave, access to worker’s compensation and unemployment insurance, antidiscrimination protection, and more of the like. Employees also have the right to unionize, whereas independent contractors do not. 

Misclassifying workers as non-employees is viewed as unlawfully withholding these benefits and protections from workers  who qualify for them. It may also be viewed as a deliberate attempt to avoid the taxes companies normally pay on behalf of their payroll employees. 

Organizations that are investigated for misclassifying workers face serious consequences, including back taxes, steep fines, damaged reputation, and missed business opportunities. 

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Employee Classification

What is the IRS 20-Factor Test?

The IRS 20-Factor Test, commonly referred to as the “Right-to-Control Test,” is designed to evaluate who controls how the work is performed. 

According to the IRS’s Common-Law Rules, a worker’s status corresponds to the level of control and independence they have over their work. While companies have the right to control how, when, and where employees perform work, they do not have that right with contractors and freelancers. 

The IRS 20-Factor Test offers 20 criteria to help determine a worker’s status, though the IRS determines the weight of each factor on a case-by-case basis. 

The 20 factors are listed below:

  1. Level of instruction. If the company directs when, where, and how work is done, this control indicates an employer-employee relationship. 
  1. Amount of training. Requesting or requiring workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which a worker performs their duties. 
  1. Degree of business integration. Workers whose services are central to the business operations or significantly affect business outcomes are likely to be considered employees. 
  1. Extent of personal services. Companies that insist or demand that a particular person performs the work have asserted a high degree of control, which indicates an employment relationship. In contrast, independent contractors are typically free to assign work to anyone. 
  1. Control of assistants. If a company hires, supervises, and pays a worker’s assistants, this control suggests an employment relationship. If the worker gets to control the hiring, supervising, and paying of assistants, they could be defined as an independent contractor. 
  1. Continuity of relationship. A continuous relationship between a company and a worker indicates an employment relationship. However, an independent contractor arrangement can also be an ongoing relationship that spans multiple, sequential projects. 
  1. Flexibility of schedule. If a company gets to dictate a worker’s days and hours of work, this degree of control suggests an employer-employee relationship. 
  1. Demands for full-time work. Workers who work full-time hours suggests a company has control over most of their time, which indicates an employment relationship. 
  1. Need for on-site services. Requiring someone to work on company premises —  particularly if the work could be performed elsewhere — suggest an employer-employee relationship. 
  1. Sequence of work. If a company requires work to be performed in specific order or sequence, this type of control suggests an employment relationship. 
  1. Requirements for reports. If a worker has to regularly provide written or oral reports on project status, they could be viewed as an employee. 
  1. Method of payment. If a worker is paid hourly, weekly, or monthly, this could suggest an employment relationship, unless the payments simply are a convenient way of distributing a lump-sum fee. It is more characteristic to pay freelancers upon project completion or commission.
  1. Repayment of business or travel expenses. Independent contractors are typically responsible for paying for travel or business expenses, and most contractors set their fees high enough to cover these costs. In contrast, reimbursement of travel and other business expenses by a company suggests an employment relationship. 
  1. Provision of tools and materials. Workers who use company-provided equipment, tools, and materials to perform their work are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor classification. 
  1. Investment in facilities. While independent contractors and freelancers usually pay for their own work facilities, most employees rely on their employer to provide work facilities. 
  1. Realization of profit or loss. If a worker’s earnings are predetermined and have little chance to realize significant profit or loss through their work, they are generally considered to be an employee. 
  1. Work for multiple companies. Workers who provide services for multiple companies concurrently are likely to qualify as independent contractors. 
  1. Availability to the public. If a worker regularly makes services available to the general public, they could qualify as an independent contractor. 
  1. Control over discharge. If a company has the unilateral right to discharge a worker, this suggests an employment relationship. In contrast, a company’s ability to end an independent contractor relationship generally depends on the terms specified in the contract. 
  1. Right of termination. Most employees can terminate their work for a company unilaterally without liability. Independent contractors cannot quit their work engagements without liability, except as permitted under their contracts.

How does the IRS 20-Factor Test differ from other tests?

Although the 20-Factor Test, the ABC Test, and the Economic Reality Test all differ, there’s a common thread between them: none provide a definitive answer on how to classify a worker. 

Here’s what each test focuses on.

IRS 20-Factor Test

As explained above, the 20-Factor Test provides criteria for assessing how much control and independence a worker has in their relationship with a hiring company. The general goal is to understand whether a business has the right to direct and control a worker’s actions. It focuses on:

  • Behavioral control
  • Financial control
  • Nature of the relationship

The ABC Test

California’s ABC Test has been at the center of state and national controversy, as plans to extend it nationwide could become reality under the pending PRO Act

Unlike the 20-Factor Test, workers can only be classified as independent contractors if they meet each of the three criteria stipulated by the ABC Test, which makes it more difficult to be classified as a contractor. The criteria are:

  1. The worker is free from the control and direction of the hiring entity in connection with the work’s performance, both under the contract for the performance of the work and in fact.
  2. The worker performs work that is outside the usual course of the hiring entity’s business.
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Currently, the majority of states rely on the ABC test for worker classification, or just A&C. 

Economic Realities Test

Under the Fair Labor Standards Act (FLSA), the Economic Realities Test determines worker classification by evaluating the extent of the worker’s economic dependence on the hiring company. 

The test includes five distinct factors, as defined by the US Department of Labor. These include:

  1. The nature and degree of the worker’s control over the work 
  2. The worker’s opportunity for profit or loss 
  3. The amount of skill required for the work 
  4. The degree and permanence of the working relationship between the worker and the potential employer
  5. Whether the work is an integral part of the hiring company’s business

With this test, each worker’s status is evaluated on a case-by-case basis, with no single factor being determinative. 

How to avoid employee misclassification penalties

The cost of employee misclassification penalties can range from costly to catastrophic. The IRS and DOL have increased their focus on misclassification in recent years, going so far as to hire additional auditors who are dedicated to investigating and penalizing companies that misclassify workers. 

The penalties, fees, and back taxes that result from misclassification can levy significant damage to some companies. å

For businesses that want to reap the benefits of freelancers and independent contractors without exposing themselves to risk, understanding the ins and outs of the tests they are subjected to is essential. 

Fortunately, companies can now run automated and continuous employee classification audits using Stoke. Stoke leverages an AI engine, based on more than 3,000 classification cases files in the US, to analyze your relationship with contractors and alerts in real time if a certain non-payroll employee might be classified as an employee.

Written by
Stoke Talent

Team

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