More and more individuals are working as freelancers and independent contractors these days—and the IRS is not particularly happy with that.

The problem is that it is sometimes difficult to determine whether an individual is an employee or an independent contractor—and this can lead to disputes with the IRS. Regardless of what label you put on a relationship, the key issue as far as taxes are concerned is control—the more control a company has over the work, the greater the chance the worker should be classified as an employee instead of an independent contractor.

Some things for you to consider:

• Does the worker only perform services for your company or does this person perform similar services for other companies?
• Does the company set the work schedule?
• Does the worker meet the criteria of a business? Does your company receive an invoice for services received? Does the worker provide his own tools? Are relevant business expenses included in the amount billed and not paid by nor reimbursed by your company? Is there a dedicated business telephone number?

When you determine an individual or a company is an independent contractor, you must have a W-9 on file unless the independent contractor is a corporation.

The courts have considered many factors in deciding whether an individual is an independent contractor or an employee. These factors fall into three main categories: behavioral control, financial control, and relationship of the parties. In each case, it is very important to consider all the factors – no single one provides the answer.

1. Behavioral control. An individual is an employee when the business has the right to direct and control the individual. For example, if the worker receives extensive instructions on how work is to be done, this suggests that he is an employee.
2. Financial control. Who controls the dollars-and-cents part of the work arrangement? For example, if the worker has a significant investment in the work, this tends to favor an independent contractor status. On the other hand, if the company reimburses the worker for business expenses, this may indicate an employer-employee relationship.
3. Relationship of the parties. How does the worker perceive the relationship? How does the company perceive the relationship? For example, if the worker receives paid leave or benefits, this favors an employee status.

The IRS would generally prefer workers be classified as employees.

• As an employee, the employer is responsible for payment of taxes. The employer withholds income taxes and the employee share of Social Security and Medicare taxes from wages. Independent contractors are considered self-employed for tax purposes and are responsible for their own tax payments.
• Employees can deduct out-of-pocket business expenses only if they itemize deductions and, even then, the deduction is limited. An independent contractor can deduct business expenses in full.
• Employees can deduct what they spend on medical insurance only if they itemize and only to the extent that their total medical expenses exceed 10% of their adjusted gross income. For an independent contractor, medical insurance premiums are deductible in full.

Parts of this article excerpted from Doing the Cleanup When a Client Loses Independent Contractor Status by Terence M. Myers, J.D. and Dorinda D. DeScherer, J.D.