3 IRS Factors You Need to Keep in Mind When Classifying Employees

October 11, 2018

Don’t make this mistake:

  • After raising $40 million, home cleaning startup Homejoy closed amid multiple lawsuits. CEO Adora Cheung said worker misclassification issues were a “deciding factor.”
  • HomeHero was forced to switch its home health aides from contractors to employees. Ultimately, the switch proved too disruptive and they shut down in Q1 of 2017.
  • Two years after launching, Sprig made the late-stage decision to change its workers from 1099s to W-2s. Despite nearly $57 million in funding, Sprig shut down in Q2 of 2017.

Classifying workers as employees or independent contractors is a fundamental element of any startup’s business. The nature of a startup’s relationship with its labor force may not only help define its culture, but may also define whether the business model is sustainable.

When is a Worker an Employee?

Many startups sensibly classify their workforce as independent contractors hoping to avoid headaches like scheduling workers, withholding taxes, and navigating federal employment laws. However, it’s not enough to hire a worker and simply define them as an independent contractor. The Internal Revenue Service (IRS) has strict classification guidelines that must be followed.

The Three IRS Factors

There is no single dispositive factor or definitive test that determines whether a worker is an employee or an independent contractor. Each case is judged on its individual circumstances. The IRS considers the degree of control and independence the worker has through these three factors:

  1. Behavioral: Who controls what the worker does and how the worker does it? Greater control by an employer will favor an “employee” designation.
  2. Financial: Is the worker independent from the company’s business? Greater employer investment (e.g., providing tools and reimbursements) favors an “employee” designation.
  3. Relationship: May the person work for other companies and is there a job finish date? An exclusive and permanent working relationship favors an “employee” designation.

What Does This Mean for Startups?

Employers who fail to properly classify workers may be liable for back wages, back taxes, and penalties plus interest. Unpaid trust fund taxes may even attach to business owners, despite bankruptcy. Startups and their legal counsel should evaluate the worker classification tests applicable in the jurisdictions where they do business (states do vary). Making proper worker classification decisions from the beginning will set the stage for business success.