Under the common law, a worker is an employee if the hiring firm (that is, the person or persons for whom services are performed) has the right to control and direct the way they work, not only with regard to the final result, but also with regard to the details of when, where, and how the work is done. According to the IRS, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.

1. Instructions.
   
   • A worker who is required to comply with instructions about when, where, and how work is to be done is ordinarily an employee.
   • Contractors are not required to follow instructions to accomplish a job.

2. Training.
   
   • Training a worker indicates that the hiring firm wants the work done in a particular way.
   • Contractors typically do not receive training by the hiring firm.

3. Integration.
   
   • Integration of the worker's services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends upon the performance of particular workers, those workers necessarily must be subject to a certain amount of control by the hiring firm.
   • Contractors should not perform work that determines the success or continuation of the hiring firm.

4. Services Rendered Personally.
   
   • If the services must be rendered personally by the worker it is presumed that the hiring firm wants the work done in a particular way.
   • Contractors usually have the right to hire others to do the actual work.

5. Hiring, Supervising, and Paying Assistants.
   
   • If the hiring firm hires, supervises, and pays assistants for a worker, that factor generally shows control over the worker.
   • Contractors must have the authority to control their own assistants.

6. Continuing Relationship.
   
   • A continuing relationship between the worker and the hiring firm indicates that an employer-employee relationship exists.
   • Contractors usually work for the hiring firm at irregular intervals, on call, or whenever work is available.

7. Set Hours of Work.
   
   • The establishment of set hours of work by the hiring firm is a factor indicating control over the worker.
   • Contractors set their own hours of work.

8. Full Time Required.
   
   • If the worker must devote substantially full time to the business of the hiring firm, then the hiring firm controls the worker, and restricts the worker from doing other gainful work.
   • Contractors should not be restricted from seeking and performing other gainful work.

9. Doing Work on Employer's Premises.
   
   • If the work is performed on the premises of the hiring firm, that factor suggests control over the worker, especially if the work could be done elsewhere.
   • Contractors control where they work. If contractors perform work on the premises of the hiring firm, the firm should not direct or supervise their activities.

10. Order or Sequence Set.
    
    • If the hiring firm sets, or reserves the right to set, the order or sequence in which work is to be performed, that factor shows control over the worker.
    • Contractors determine the order and sequence of their work.

11. Oral or Written Reports.
    
    • A requirement that the worker submit regular or written reports to the hiring firm indicates a degree of control.
    • Contractors are hired to produce a final result, and therefore should not be required to submit interim reports.

12. Payment by Hour, Week, Month.
    
    • Payment by the hour, week, or month generally points to an employer-employee relationship.
    • Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor. Contractors may accept periodic payments based on a percentage of work completed, or some other fixed schedule determined before the job begins.

13. Payment of Business and/or Traveling Expenses.
    
    • If the hiring firm ordinarily pays the worker's business and/or traveling expenses, the worker is ordinarily an employee. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker's business activities.
    • Contractors pay their own incidental expenses.

14. Furnishing of Tools and Materials.
    
    • The fact that the hiring firm furnishes significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship.
    • Usually contractors furnish their own tools, materials, and other equipment. If the hiring firm provides such items, they should be leased to the contractor at fair market rate.

15. Significant Investment.
    
    • Lack of investment in separate facilities, such as maintenance or rental of one's own office, indicates dependence on the hiring firm, and accordingly, the existence of an employer-employee relationship.
    • Contractors should be able to do their work without using the hiring firm's facilities. The contractor's investment in their trade must be real, essential and adequate.

16. Realization of Profit or Loss.
    
    • Employees do not realize entrepreneurial profit, and are not at risk of loss, as a result of their work for the hiring firm.
    • Contractors should be able to make a profit or suffer a loss as a result of their work for the hiring firm.

17. Working for More Than One Firm at a Time.
    
    • The hiring firm may restrict its employees from working for another firm, such as a competitor, as a condition of employment.
    • Contractors are not restricted from working for more than one firm at a time.

18. Making Service Available to General Public.
    
    • Employees work primarily for the hiring firm.
    • Contractors make their services available to the general public on a regular and consistent basis.

19. Right to Discharge.
    
    • An employer exercises control through the threat of dismissal, which causes the worker to obey the employer's instructions.
    • An independent contractor, on the other hand, cannot be fired so long as the independent contractor produces a result that meets the contract specifications.

20. Right to Terminate.
    
    • Employees have the right to terminate their relationship with the hiring firm at any time without incurring liability.
    • Contractors are responsible for the satisfactory completion of their contractual obligation, and may be subject to a penalty or legal action if they fail to complete the agreed upon work.

The above list is adapted from IRS Revenue Ruling 87-41 Listing the 20 Common Law Factors -- Complete Text (1987-1 CB 296). You should consult a legal or tax advisor for advice concerning specific questions and situations. An excellent and informative summary of legal issues related to the hiring of independent contractors may be found in Independent Contractors: A Manager's Guide and Audit Reference, published by the California Chamber of Commerce, P.O. Box 1736, Sacramento, CA 95812-1736, (916) 444-6670. Another excellent resource is Hiring Independent Contractors: The Employer's Legal Guide (1997) by Stephen Fishman, published by Nolo Press. An in-depth and comprehensive discussion of employee vs. independent contractor legal issues is available on-line at Fenwick & West: Publications.

In 1996 the IRS issued a new training manual for its auditors that clarifies somewhat the distinction between employee and independent contractor. The manual advocates a less adversarial approach to classifying workers, and acknowledges that hiring an independent contractor instead of an employee "can be a valid and appropriate business choice". Guidelines in the IRS training manual are more permissive than the original twenty common law factors. The IRS training manual would seem to permit independent contractors to be paid by the hour, participate voluntarily in client provided training programs, work for a single client over a long period of time, work on the client's premises, and accept suggestions from the client about how work is to be done.

No single factor or mix of factors is necessarily sufficient to qualify an independent contractor as an employee. However, since any one factor alone can result in a contractor being reclassified as an employee, hiring firms are usually advised to demonstrate lack of control for all twenty common law factors. The severe consequences of "losing" in an IRS or EDD audit, coupled with a highly unpredictable appeals process, makes it imperative that all parties play it extremely safe.

The twenty common law factors, even when modified by guidelines in the new IRS training manual, place severe limitations on how clients interact with their contract workers. Most companies deal with this issue by disconnecting as much as possible from their contractors' work. The result for contractors is freedom and greatly reduced levels of stress. It is this freedom (as well as the money) that is so attractive to contract workers.

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The preceding discussion addresses primarily the subject of independent contractors, and NOT contract employees. Nevertheless, the issues related to the hiring of independent contractors directly impact the working environment of contract employees. Indeed, the issues related to the hiring of independent contractors are largely, if not wholly, responsible for creating the entire industry of contract employment agencies.

Hiring firms are at risk from the IRS and other agencies whenever they employ independent contractors. One mistake by the hiring firm or its employees, and an independent contractor can be converted into an employee. The IRS now investigates the status of independent contractors in all business audits they conduct. And the burden of proof is always on the hiring firm to demonstrate unequivocally that an independent contractor is NOT their employee.

If the matter goes to court, and the hiring firm wins, the legal cost of successfully defending itself can be huge. If the hiring firm loses, the cost is greater still. It is not surprising that hiring firms seek to protect themselves from legal attack by scrupulously heeding the twenty common law factors. The twenty common law factors address the two defining characteristics of independent contractors:

1. The hiring firm has no right of control over an independent contractor.
2. An independent contractor is an entrepreneur operating an ongoing business.

Nevertheless, it is difficult to abstain completely from exercising control over workers. And, frequently some level of control is essential to the success of a project, especially if the project is not well defined, if workers are expected to use company resources, and when the project requires a team effort. One solution is to hire an outside consulting firm. A more frequent solution is to use the services of a contract employment agency. The contract employment agency hires the workers, and withholds all applicable State and Federal taxes, Social Security, unemployment, and disability premiums. Then they "lease" the workers to their client under the terms of a formal contract. This practice addresses the major concerns of the IRS, EDD and other government agencies, namely that taxes are paid and workers receive their government benefits.

Also, when workers are employed by a contract employment agency there is little question that they are, indeed, bona fide employees, and not independent contractors. Hence the term, contract employee. Some companies also require that independent contractors use an employer of record, such as a pass through agency or employment broker. An employer of record, acting as an intermediary, bills the client and handles the paperwork, thus converting the independent contractor into a contract employee. The employer of record then has the option of treating the worker as a bonafide employee by withholding taxes and issuing a W-2 form, or of treating the worker as an independent contractor. In either case, from the client's perspective the worker is a "contract employee".

We must note, however, that an employer of record who pays a "contract employee" as an independent contractor places the client company at risk when the IRS conducts their next audit. If the IRS catches the disparity, and the the contractor fails to satisfy the twenty common law factors, the IRS can evoke the co-employment rule, reclassify the independent contractor as an employee of the client, and go after the deeper pockets of the client company.

Contract employment agencies offer the protection that businesses need to avoid problems with the IRS. But there are chinks in the armor. Because most companies offer their employees more and better benefits than do the contract employment agencies, it can still be argued that some client companies use contract employees to avoid paying benefits. To counter this claim, companies may impose an arbitrary upper limit on the length of individual assignments. This practice is aimed at stemming the possibility that a contract employee will convert by default to one of the client's employees simply by virtue of having worked so long under its direction and control.

There is another, subtle issue that absolutely colors the entire relationship between a client company and its contract employees. It all comes down to this question: How can corporate managers be expected to know which contractors are independent contractors, and which are contract employees, and then treat each appropriately according to the twenty common law factors? The answer is they can't. Consequently, the safest approach is to treat all contractors as if they were independent contractors. Because of this ambiguity, contract employees often experience the two-sided coin of exceptional freedom to do one's work with minimal interference, while receiving little or no support from the client's own employees.

As you can see from the foregoing discussion, contract employment agencies provide insurance against the risk that the IRS and other government agencies will reclassify independent contractors as employees. The impact on contract employees is profound.

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Contract Employees
There is no reason for a contract employee to incorporate. For that matter, there is no reason to take out a business license, publish a fictitious name statement, register with your state's Board of Equalization, or do anything else that would imply you are in business. If you are employed, and your employer withholds taxes from your paycheck, then you are an employee. Contract employees are bona fide employees who have no reporting obligations other than stating the number of withholding allowances on a W-4 form. Contract employees are not in business. Consequently, they have none of the obligations of a person who is in business. On the down side, employees also have few of the business deductions and other tax advantages available to independent contractors.

Independent Contractors
If you are considering adopting independent contractor status, you should consult with an accounting professional who has experience managing the accounts of independent contractors. You will also want to read books about consulting and setting up a small business, some of which are listed in this Handbook's section called Internet and Print Resources. As an independent contractor you will be in business for yourself. It is a big step, and the consequences, both legal and financial, of messing up can be significant. That is why many experienced (would-be) independent contractors choose to operate exclusively on a W-2 basis. In fact, if this handbook has only one message, it is this: The contract employee who thinks and acts like an experienced independent contractor will prosper, and have few of the headaches associated with running one's own business.

Typically, the independent contractor who operates as a sole proprietorship is paid by the client's payroll department on a 1099 basis. If the independent contractor is represented by a partnership, limited liability company, or corporation, the independent contractor is paid as any other vendor on an accounts payable basis.

Consider the following employment options. As a contract worker you are either:

1. Employed by someone else, or
2. Self-employed, in which case you are in business as one of the following:
   1. Sole Proprietorship,
   2. Partnership,
   3. Limited Liability Company, or
   4. Corporation, in which case you are probably either a:
      1. C Corporation, or an
      2. S Corporation.

Sole Proprietorship
Many independent contractors choose to operate as a sole proprietorship. In fact, sole proprietorship is the default status of all self-employed workers. There is no special form or application to fill out, and it doesn't cost a cent to become a sole proprietor, although local jurisdictions may require that you file a fictitious name statement (if your business has a name other than your own) and take out a business license. And, like all businesses, sole proprietorships are required to withhold their own taxes. Additionally, sole proprietors must pay both the employer's and the employee's regular contributions to FICA/Medicare. This is the so-called self-employment tax. Independent contractors operating as a sole proprietorship are paid on a 1099 basis. Sole proprietor status provides no personal protection to the independent contractor against law suits and other adverse legal actions directed toward the business.

A principle advantage of being self-employed is being able to deduct business expenses when calculating one's personal income taxes. The business expenses of a sole proprietorship are itemized on Schedule C, and filed with the owner's annual tax returns.

Partnership
There is no rational reason why an independent contractor would choose to operate in a formal partnership with one or more business partners. In a partnership each partner is personally liable financially for the actions of the other partner(s). A partnership can be your worst nightmare. Case in point: Marriage is the legal equivalent of a business partnership. (Ouch!)

Limited Liability Company
The limited liability company, or LLC, is a relatively recent form of business in the United States, although it is quite common in other countries. The LLC allows partners to pay their taxes as a partnership, with earnings and expenses passed through the business to the individual partners who then file separate tax returns. The advantage of the LLC is that it protects each partner against financial liability for the actions of another partner. Because the LLC is a new form of business, it has yet to gain popularity, or receive uniform legal treatment from state to state. And, some states do not yet recognize the LLC as a legal form of business. Consequently, operating as an LLC may not be practical if your consulting business has earnings in more than one state.

Incorporation
Incorporation provides the greatest personal protection from liability arising from the actions of the corporation itself, or from its officers and employees. Incorporation also provides the greatest potential leverage against taxes. Those are the advantages. The disadvantages are the costs associated with setting up and maintaining the corporation.

The C corporation is the default form of corporation. In this type of corporation earnings are taxed twice; first at the corporate level, and then again when they are distributed as salaries and dividends. The S corporation avoids this double taxation by passing all income through to the shareholders without incurring taxes at the corporate level. For this reason, most incorporated independent contractors are S corporations. S corporations are limited compared with C corporations in the types of business deductions they can claim. Still, S corporations allow significantly more deductions than do sole proprietorships.

If you are considering incorporation, you will definitely want to consult with an accountant, and possibly an attorney, to make sure you do it right. You will need an accurate accounting system, and good advice on what records you should keep. It is essential that you get advice from professionals who have worked extensively with independent contractors, preferably in your area of expertise. Ask your fellow contractors for referrals, and interview several professionals before you make a selection. The price of a good accounting professional will be repaid many times over by the taxes you save and the penalties you avoid.

Yes, many independent contractors are incorporated. But don't incorporate simply because you want to become an independent contractor. In fact, unless your clients require that you be incorporated, or you already have a thriving consulting business, it is probably unnecessary, even unwise, to incorporate at all. Many clients are just as happy working with a sole proprietor as with a corporation.

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