In this transcript from a video by Steven J Wick & Associates PC in Fort Collins, we discuss the IRS three factor test for worker classification and how to determine whether a worker should be classified as an independent contractor or an employee. Steve Wick explains the behavioral, financial, and relationship tests that the IRS and Colorado Department of Labor use to evaluate worker status.
To learn more about how to properly classify workers and avoid misclassification issues, check out our detailed article on independent contractor vs employee rules in Fort Collins.
This video provides general guidance for educational purposes only and does not constitute legal advice. We strongly recommend contacting a CPA or employment law professional regarding your specific situation.
00:00:00 – Introduction & Three-Factor Test
Foreign. [Music] [Music] It comes down to—it’s a three-factor test. The IRS uses these, and the Colorado Department of Labor also uses a lot of these questions and factors. The first one is a behavioral test.
Do you control when they show up to work, when they leave, when they take their breaks, what they do? Are you evaluating their work and guiding them on the job? Or is it more of a “bit factor” where there is some evaluation even with independent contractors?
00:01:17 – Financial Test
Some extent, but most of the time, they are independent in doing their job. The financial test is a question of: Are you paying them regularly, like weekly or bi-weekly, on that type of schedule? Are they eligible for reimbursement for various costs? Are you providing the tools, or are they using their own tools for the job? Do they carry their own insurance for errors and omissions or some type of liability insurance?
Ultimately, who is financially responsible? Are you going to pay them to fix their screw-ups if they mess up a job, or are they going to have to do it for free? That’s the ultimate thing—it’s like on a bid basis, if you will.
00:01:55 – Relationship Test
The final piece is the relationship test. Are you paying them time off, fringe benefits, vacation pay, retirement, or other similar perks? Are the services basically indefinite, or are they for a specific project? Is there a written agreement that favors the independent contractor? Are they giving you invoices for every job they complete?
Contracts and documentation help establish independent contractor status, but they have to have all those things in place. Are they registered with the city? Just think of all the things you had to go through to start your business—they need to do the same. If not, they can be reclassified as employees.
00:02:28 – Penalties & Precautions
And like I said, penalties are huge. If you paid them, let’s say, 10,000 payments, they can be reclassified—and there could be another ten to fifteen thousand dollars easily in penalties, plus other taxes and fees you would have to pay on top of that. So be very careful. [Music]
Conclusion: IRS Three Factor Test for Worker Classification
Understanding the IRS three factor test for worker classification is critical for any business hiring employees or independent contractors. Misclassification can result in significant penalties, so always ensure proper documentation, contracts, and adherence to behavioral, financial, and relationship tests. For personalized guidance, we recommend consulting a CPA or employment law professional to review your specific situation.
