17.2 Classification of Independent Contractors Versus Employees
Overview
The University of Illinois System classifies and pays individuals who provide services as employees, unless the nature of the services and other circumstances satisfy the criteria for independent contractor status. Section 3121(d)(2) of the Internal Revenue Code (IRC) provides that the term "employee" means any individual who, under the common law rules applicable in determining the employer-employee relationship, has the status of employee. The Internal Revenue Service (IRS) ignores contract labels, and instead examines the facts and circumstances of each situation and analyzes specific characteristics, such as behavioral and financial control and the relationship between the employer and the individual performing services, before a determination can be made whether the individual is classified as an employee or an independent contractor under common law.
Once an employer-employee relationship is established, the employer is required to withhold the appropriate income and employment taxes. Penalties may be imposed by the IRS in instances where the employer fails to properly withhold such taxes.
This section incorporates the IRS guidelines that are currently in effect.
Classification of Service Providers
Before the performance of services commence, departments contracting for services must assess the relationship with the individual providing services to ensure that individuals hired or contracted to perform services are properly classified as an employee or an independent contractor. An initial misclassification may result in a substantial delay in payment. It is the system's responsibility to designate an individual's status as an employee or an independent contractor.
Employee - An individual who performs services subject to the employer's right to direct and control the work is classified as an employee. The employer can allow the employee considerable discretion and freedom of action, provided that the employer has the legal right to direct or control the work.
Former or Current Employee – A former employee who returns to work in some capacity or a current employee who is to perform a second and different job usually is classified as an employee. This is especially the case if the work to be performed is the same or similar to the work previously performed by a former employee or being performed by a current employee. However, the individual may need to be classified as an independent contractor. It is important to consider the specific facts of the proposed working relationship in light of the IRS and 20 Common Law Factors before classifying the worker for income tax purposes.
Units should work with their human resources office and Tax Compliance and Analysis for assistance with worker classification determinations.
Retired University Employees - Former system employees, who are State University Retirement System (SURS) annuitants, are prohibited from seeking re-employment before sixty (60) days from retirement date. For additional information on re-hiring retired system employees see Academic Human Resources Web site on the Rehiring of University of Illinois Retirees .
Independent contractor - An individual who performs services wherein the employer has the right to control or direct only the result of the work, but not the means and methods of accomplishing the result, is classified as an independent contractor.
Withholding Requirements
Unless otherwise exempt from required withholdings, the system is required to withhold certain deductions from wage payments. For additional information, see 4 Payroll. If the individual is classified as an independent contractor, the system is not responsible for withholding income and employment taxes. However, the system is responsible for reporting compensation over $600 paid to individuals who are classified as independent contractors on Form 1099-MISC, Miscellaneous Income to the IRS.
Penalties for Misclassification
The IRS may assess penalties for misclassification of an individual providing services to the system. If an individual is determined by the IRS to be an employee instead of an independent contractor, the system may be held liable for the individual's employment taxes, penalties and interest assessed for not withholding income and employment tax, and a separate misclassification penalty. As provided under IRC Section 3509, an employer is liable for 1.5 percent of wages paid if the employer erroneously treats the individual as a nonemployee for Federal income tax withholding purposes, and the penalty increases to 3 percent if no information returns were filed. The department will be responsible for the payment of additional taxes, penalties, and interest assessed.
However, liability for Federal employment taxes may be relieved under Section 530 of the Revenue Act of 1978, also commonly referred to as Section 530 Safe Haven Relief. Section 530 Safe Haven Relief protects employers who have consistently treated workers as independent contractors. The rule provides that an individual who has not been treated as an employee will not be reclassified as an employee if (1) the employer had a reasonable basis for not treating the individual as an employee, (2) the employer did not treat the individual or any individual in a similar position as an employee for payroll tax purposes, and (3) the employer has filed all required Federal tax returns, including information returns, in a manner consistent with the individual not being an employee.
Common Law Rules
Prior to 1997, the IRS used twenty common law factors derived from case law and rulings in determining whether an individual performing services is classified as an employee or an independent contractor. However, all factors were not necessarily pertinent or present in all situations. Also, as previously mentioned, all the facts and circumstances of each case need to be considered. Additional relevant information that assists in determining the extent to which the individual or employer for whom services were performed retained the right to control should also to be considered.
Therefore, although the twenty common law factors referenced below are still taken into account, simply another way of analyzing the pertinent factors is to focus on (1) behavioral controls, (2) financial controls, and (3) the relationship between the employer and the individual performing services. These three main categories are described below and additional detailed information may be found at IRS Publication 1779, Independent Contractor or Employee and at IRS Publication 15-A, Employer's Supplemental Tax Guide under the "Employee or Independent Contractor?" section.
Behavioral Control
Behavioral controls are evidenced by facts that determine whether the employer has a right to direct and control how the individual performs the tasks for which the individual is hired, including the type of instructions (how, when, and where to work) the employer gives the individual and how the individual obtains training for providing such services.
Financial Control
Financial controls are evidenced by facts that determine whether the employer has a right to direct or control the financial/business aspects of the individual's business activities, including (1) the extent to which the individual is reimbursed for business expenses, (2) the extent of the individual's investment in the business and whether a profit or loss is realized, (3) the extent to which the individual offers similar services to the relevant market, and (4) how the employer pays the individual, such as hourly, salary, or a flat fee.
Type of Relationship
The relationship between the individual performing services and the employer is evidenced by examining how the employer and the individual perceive their relationship, including (1) whether a written contract exists explaining the employer's and individual's intent, (2) the provision of, or lack of employee benefits, (3) the permanency of the relationship, (4) the right to terminate the relationship, and (5) the extent to which services are performed that are a part of the employer's regular business activities.
Twenty Common Law Factors
Revenue Ruling 87-41, 1987-1 Cumulative Bulletin 296 (Rev. Rul. 87-41) provides the list of 20 Common Law Factors to assist in determining whether an individual should be classified as an employee or an independent contractor. These factors are intended as guidelines, not as strict rules. In fact, Rev. Rul. 87-41 states, "The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed." Listed below are five basic questions that capture the essence of the twenty common law factors, which may assist in clarifying the determination of employment status:
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No
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Will this individual provide essentially the same service as provided by a university employee?
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Has the individual previously been paid as a university employee to perform essentially the same tasks?
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Will the university have a legal right to control how the individual will perform or accomplish the service?
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Will the individual supervise or direct university employees as part of the service provided?
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Is it currently expected that the university will hire this individual as an employee immediately following the termination of the contractual service provided?
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If the answer to any of these five questions is yes, then the individual provider in question most likely should be classified as an employee, and the person certifying the status should contact the Office of Human Resources at UIC, the OBFS, University Payroll at UIS, and the Office of Academic Human Resources or Personnel Services Office at UIUC.
Contracting Procedure
If the answers to all of the above five questions are no, an independent contractor relationship may be established (see 17.1 Consultants and Other Contractors for Services). The Office of Business and Financial Services reserves the right to request verification of the individual's classification as an independent contractor from the Office of Human Resources.
If an individual believes that the system has assessed an inappropriate determination, he or she may submit Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding to the IRS. While waiting for the IRS's determination, in which the IRS notes in the instructions for Form SS-8 that this process takes approximately 120 days, the individual provider will be paid as an employee. If the IRS determines the correct classification to be an independent contractor, the taxes withheld will be remitted to the individual.
Last Updated: May 29, 2019 | Approved: Senior Associate Vice President for Business and Finance | Effective: March 2008