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Whether your workers are independent contractors or employees is determined by the circumstances surrounding the performance of each worker’s services for you, not by submitting a Form 1099 or Form W-2 to the IRS. Many employers make the mistake of unilaterally and summarily classifying their workers as independent contractors without actually analyzing the necessary factors.

An employer’s legal rights and obligations may change – sometimes dramatically – depending on whether the relationship created is one of independent contract or one of employment. There are certainly benefits to engaging independent contractors rather than employers. Taxes are not deducted from payments made to an independent contractor, you don’t have to carry workers’ compensation insurance on independent contractors, and you are not potentially liable for the actions of your independent contractors. However, as appealing as that relationship may be, the actual determination requires a case-by-case analysis of the circumstances surrounding the worker.

The IRS has established a twenty factor test to use in determining independent contractor status. These factors include:

• Does the individual perform functions that are an essential part of the company’s normal operations, or does the individual operate an independent business?
• Does the company train the individual in the manner and means of performing the work in question?
• Must the individual perform the work personally, or may he or she find others to perform it?
• Does the individual have a permanent working relationship with the company that will continue as long as the work is satisfactory?
• Does the individual do business in the company’s name, with assistance and guidance from other company personnel?
• Is the agreement that contains the terms and conditions under which the individual operates determined by both the company and the individual, or only unilaterally by the company?
• Is the individual paid by the task or by the time spent?
• Does the individual furnish his or her own equipment and materials to perform the work or are they furnished by the company?
• Are particular skills required for the operations being contracted for?
• Does the individual have a proprietary interest in the work, with investment and the opportunity for profit and the risk of loss?
• Does the individual have the opportunity to make decisions that may result in profit or loss?
• Is the individual free to perform the services for others at the same time, or are they to be performed only for the company?
• How much supervision is exercised by the company over the means and manner of the individual’s work?
• What do the actions and words of the company and the individual demonstrate as to their intent to create an independent contractor or an employee relationship?
• What differences or similarities in treatment exist between how the company treats the individual in question and how the company treats its acknowledged employees?

Not every factor can always be considered so courts and governmental agencies will use a balancing test, with emphasis placed on who controls how the work is performed and how the relationship actually works. You should be aware that a written agreement between the parties is only one factor and will not necessarily control the determination.

Let’s take a look at the circumstances surrounding two different jockeys and make the determination as to whether either qualify as an independent contractor.

Jockey 1: Arrangements for rides are made by the jockey or by an agent of the jockey who receives a commission from the jockey. The jockey is free to ride the horses of any stable. The jockey is free to accept or reject a call. The jockey provides his or her own saddle. The trainer instructs the jockey regarding the nature of the mount, the setup of the race, and the trainer's expectations of the running of the race. The jockey is free to disregard the instructions of the trainer, and may decide the route to be taken, the rate of speed of the horse, and similar matters regarding the running of the race. Payment is a fee paid on a per-race basis.

Jockey 2: The jockey rides only for the employing trainer or the jockey rides for other trainers only with the permission of the employing trainer. The jockey is not free to reject the employing trainer's call. The trainer provides or pays for the jockey's saddle. The jockey is not free to disregard the instructions of the trainer regarding the running of the race except for safety reasons. The jockey is paid a salary or wage by the trainer on a time rather than per-race basis; compensation usually includes room and board.

Using the twenty factor test and the information provided in the examples, Jockey 1 is likely to be an independent contractor, while Jockey 2 is likely to be an employee. Jockey 1 demonstrates a clear freedom in deciding whether to provide his services, provides his own equipment, and is paid on a per-race basis, rather than an hourly wage. On the other hand, Jockey 2 has little to no control over whether to take a ride and how to execute the ride, doesn’t provide his own equipment, and is paid on a salary basis. These examples illustrate how important it is to consider the twenty factors and analyze the relationship that actually exists between your business and your workers instead of summarily categorizing them as employees or independent contractors.

In the event the IRS or Department of Labor audits your business and finds that you have been misclassifying employees as independent contractors, you may be liable for a significant amount of back taxes, back wages, and unpaid overtime. If these expenses are not something you have accounted for, your business may be in serious financial trouble.