employee or contractor?

IRS 20-Factor Test for Employee vs. Independent Contractor Status – Updated for Tech, Finance, and Legal Sectors

Following landmark cases, such as the 1992 Microsoft lawsuit where temporary workers claimed employee benefits, organizations in the tech, finance, and legal sectors have adopted stringent policies to classify workers accurately as employees or independent contractors. LXI, while flexible in meeting consultants’ compensation needs, adheres to IRS guidelines and industry best practices to ensure compliance with federal and state regulations.

The IRS applies a common-law test focused on control to determine worker status: Does the principal (employer) control or have the right to control the worker’s tasks and methods? Revenue Ruling 87-41 (1987-1 CB 296) outlines 20 factors to assess whether a worker is an employee or independent contractor. While the IRS now emphasizes three categories—Behavioral Control, Financial Control, and Relationship of the Parties—the 20-factor test remains a critical tool for detailed analysis, especially in tech, finance, and legal contexts where nuanced work arrangements are common.

Key Notes:

• The taxpayer (employer) bears the burden of proof to justify independent contractor status.

• No single factor is decisive; the IRS evaluates the overall relationship.

• Historically, at least 11 factors were suggested to support independent contractor status, but this is a guideline, not a rule.

• Misclassification risks significant penalties, including back taxes, fines, and liability for benefits, particularly in heavily regulated sectors like finance and legal.

The 20-Factor Test

For the first 15 areas, a “Yes” answer suggests the worker is an employee. For areas 16–20, a “Yes” answer suggests the worker is an independent contractor.

• Instructions: Does the principal provide specific instructions on when, where, and how the worker performs tasks?
  (Yes = Employee)
  Example: A tech firm mandating a developer’s coding framework or a law firm dictating a contract attorney’s drafting process indicates employee status.

• Training: Does the principal provide training on job performance or proprietary processes?
  (Yes = Employee)
  Example: A finance firm offering compliance training or a tech company requiring onboarding for internal tools suggests an employee relationship.

• Integration: Are the worker’s services integral to the principal’s core business operations?
  (Yes = Employee)
  Example: A data scientist at a fintech company or a paralegal at a law firm, whose work is central to operations, is likely an employee.

• Personal Services: Must the worker personally perform the services, or can they delegate tasks?
  (Yes = Employee)
  Example: A legal consultant unable to subcontract research tasks or a developer restricted from outsourcing coding suggests employee status.

• Assistants: Does the principal hire, supervise, or pay assistants for the worker?
  (Yes = Employee)
  Example: A finance firm providing support staff for a consultant or a tech company assigning junior developers to a lead indicates an employee relationship.

• Continuing Relationship: Is there an ongoing or long-term relationship between the worker and the principal?
  (Yes = Employee)
  Example: A contract attorney retained indefinitely by a law firm or a programmer working years for a tech company leans toward employee status.

• Set Hours: Does the principal dictate the worker’s work hours or schedule?
  (Yes = Employee)
  Example: A finance analyst required to work market hours or a tech worker assigned sprint schedules suggests employee status.

• Full-Time Work: Does the worker dedicate substantially full-time effort to the principal’s business?
  (Yes = Employee)
  Example: A legal researcher working exclusively for one firm or a fintech developer committed to a single platform indicates employee status.

• Work Location: Is the work performed at the principal’s premises or a designated location?
  (Yes = Employee)
  Example: A lawyer working at a firm’s office or a tech worker using company servers suggests employee status.
  Note: Remote work is common in updated work arrangements, but control via virtual oversight (e.g., mandatory Zoom check-ins) may still indicate employee status.

• Order or Sequence: Does the principal control the order or sequence of the worker’s tasks?
  (Yes = Employee)
  Example: A tech firm setting agile sprint priorities or a finance firm dictating audit steps suggests employee status.

• Reports: Does the worker submit regular oral or written reports to the principal?
  (Yes = Employee)
  Example: A developer providing daily stand-up updates or a financial consultant submitting weekly compliance reports indicates employee status.

• Payment Method: Is the worker paid by the hour, week, or month rather than by project or deliverable?
  (Yes = Employee)
  Example: Hourly pay for a contract attorney or monthly salaries for a tech worker suggest employee status, while per-project fees lean toward contractor status.

• Right to Discharge: Can the principal terminate the worker at will without cause or liability?
  (Yes = Employee)
  Example: At-will termination of a fintech analyst or a legal researcher indicates an employee relationship.

• Worker’s Termination Rights: Can the worker end the relationship at any time without liability (e.g., no contract breach)?
  (Yes = Employee)
  Example: A tech worker resigning without penalty or a finance consultant leaving freely suggests employee status.

• Expenses: Does the principal reimburse business or travel expenses?
  (Yes = Employee)
  Example: Covering conference travel for a legal consultant or software licenses for a developer indicates employee status.

• Tools and Materials: Does the worker provide significant tools, materials, or equipment?
  (Yes = Independent Contractor)
  Example: A freelance developer using their own laptop and IDE or a financial advisor supplying proprietary software supports contractor status.

• Investment in Facilities: Does the worker maintain significant investment in facilities (e.g., office, cloud infrastructure)?
  (Yes = Independent Contractor)
  Example: A contract attorney with a home office or a tech consultant leasing cloud servers indicates contractor status.

• Profit or Loss: Can the worker realize a profit or incur a financial loss from their services?
  (Yes = Independent Contractor)
  Example: A freelance coder bidding on projects or a financial consultant covering marketing costs risks profit/loss, supporting contractor status.

• Multiple Clients: Does the worker provide services to multiple clients or firms simultaneously?
  (Yes = Independent Contractor)
  Example: A legal consultant serving multiple firms or a tech contractor coding for several startups supports contractor status.

• Availability to Public: Does the worker advertise or make their services available to the public?
  (Yes = Independent Contractor)
  Example: A finance advisor with a public website or a developer listing services on platforms like Upwork indicates contractor status.

Sector-Specific Considerations for Updated Work Environments

• Tech Sector:

  • Remote Work: Many tech workers operate remotely, but company-mandated tools (e.g., proprietary IDEs) or schedules (e.g., sprint cycles) may indicate employee status.

  • Gig Platforms: Developers on platforms like GitHub or Upwork often exhibit contractor traits (e.g., multiple clients, self-provided tools).

  • Equity Compensation: Stock options or RSUs for tech workers may blur lines; IRS focuses on control, not compensation type.

  • Example: A machine learning engineer working remotely but attending daily stand-ups and using company cloud credits is likely an employee.

• Finance Sector:

  • Regulatory Oversight: Compliance requirements (e.g., SEC, FINRA) often necessitate training or reporting, leaning toward employee status.

  • Consulting Roles: Independent financial advisors with multiple clients and self-funded certifications (e.g., CFA, CFP) are typically contractors.

  • Example: A risk analyst paid hourly and using firm-provided Bloomberg terminals is likely an employee, while a freelance CPA with a public practice is a contractor.

• Legal Sector:

  • Contract Attorneys: Often hired for specific cases, but firm-controlled workflows or long-term engagements suggest employee status.

  • Bar Requirements: Independent attorneys must maintain their own malpractice insurance and CLE credits, supporting contractor status.

  • Example: A contract attorney drafting briefs under firm supervision is likely an employee, while a solo practitioner serving multiple clients is a contractor.

Additional Considerations

• State Laws: States like California (AB5, modified by Proposition 22) use stricter tests (e.g., ABC test) for worker classification, impacting tech and finance sectors. Ensure compliance with both federal and state regulations.

• Remote Work: In updated work environments, virtual oversight (e.g., mandatory Slack updates, company VPNs) can indicate employee status despite physical separation.

• Contracts: Written independent contractor agreements are critical but not conclusive if the relationship resembles employment. Include clear terms on deliverables, payment, and autonomy.

• IRS Resources: Use Form SS-8 for status determinations or the Voluntary Classification Settlement Program (VCSP) to correct misclassifications with reduced penalties (see irs.gov).

• Penalties: Misclassification risks tax liabilities, wage claims, and regulatory scrutiny, especially in finance and legal sectors with strict compliance mandates.

LXI Policy

LXI upholds rigorous compliance with IRS guidelines and sector-specific regulations. We evaluate worker relationships using the 20-factor test and other IRS criteria to ensure accurate classification. Consultants in tech, finance, and legal roles are encouraged to maintain documentation (e.g., business licenses, client contracts, public listings) to support independent contractor status when applicable.

Recommendations for Tech, Finance, and Legal Sectors

• Document Relationships: Draft clear contractor agreements specifying project scope, deliverables, and autonomy. Avoid terms implying control (e.g., “supervise”).

• Leverage Technology: Use platforms like Upwork or LinkedIn to establish public availability, reinforcing contractor status.

• Monitor Control: Minimize instructions, training, or company-provided tools for contractors. Allow flexibility in work methods and schedules.

• Regular Audits: Reassess long-term engagements to prevent “employee-like” relationships, especially for remote tech workers or contract attorneys.

• Compliance Training: Ensure HR and legal teams understand IRS and state-specific rules (e.g., California’s ABC test) to avoid misclassification.

• Consult Experts: Engage tax or legal advisors for complex cases, particularly in finance and legal sectors with regulatory overlays.

• Stay Updated: Monitor IRS guidance and state law changes via irs.gov or industry resources like SHRM or ABA.

For further details, visit irs.gov or consult a tax/legal professional specializing in tech, finance, or legal sectors.