Now that tax season is over, it’s a good time to plan for next year. Many companies large and small use workers that they designate as independent contractors. Unfortunately, many companies, including some big ones like Microsoft, have run afoul of the Internal Revenue Service (IRS) because of this practice.

Take The Best Web Design Firm, a small company that designs websites and Internet-based products. Best Web has a staff of five full-time employees who develop the websites and Internet products. On occasion, the company supplements its regular workforce with independent contractors such as graphic artists.

For example, Macy, a graphic artist, is called at least twice a month to assist on projects. She attends meetings with clients and sometimes works at the Best Web office. When working with Best Web clients, she is not identified as an independent contractor. When working out of the Best Web site, Macy follows the schedule that the company gives her. She is paid on an hourly basis. She also does work for other companies. Neither Best Web nor Macy considers Macy an employee.

Imagine their surprise when they learned that the IRS considers her an employee.

In today’s environment, a technology company’s workforce typically consists of regular employees, temporary employees, and consultants or independent contractors. A company's legal obligations to its employees differ from its legal obligations to the independent contractors and consultants it uses.

With respect to employees, a company has to withhold federal and state taxes from wages, pay unemployment tax, and pay social security taxes. Failing to pay these taxes can have dire results. Not only does the company run the risk of back taxes, fines, and penalties, the company’s benefit plans can be impacted as well.

A company must know legally whether the worker it is using is an employee. This is true not just for tax purposes, but also for other legal purposes.

Employers mistakenly believe that having a written agreement with a consultant or independent contractor that states that the worker is not an employee is sufficient to prove that the worker is indeed not an employee. This is not the case.

The IRS distinguishes between an employee and an independent contractor by looking at the circumstances surrounding the worker(s) and applying a test called the "right to control test" to those circumstances.

The IRS looks to see whether or not the employer has the right to control the manner and means of the work. The test hinges on the right to control, not the actual exercise of control. If the employer has the right to control, it is not relevant that an employer may not actually exercise that right.

In determining the right to control, the IRS looks at questions such as the following:

• Is the work done at a company-owned site?
• Can the worker just quit or be discharged?
• Who provides the equipment necessary to perform the work?
• Does the worker maintain its own facilities?
• Does the worker do work for more than one company?
• Does the worker have to provide an oral or written report regarding the work or its progress?
• Are the worker’s services an integral part of the work carried out by the company?
• Does the company instruct the worker as to how to perform the services?
• Is there a continuing relationship between the company and the worker?
• Does the worker spend a significant portion of his or her time working for the company?
• Does the company train the worker?
• Does the work have to be performed in an order or sequence determined by the company?
• Can the worker realize a profit or suffer a loss as a result of his or her services?

It is not always clear when a worker is an employee or an independent contractor. The test is not cumulative and cannot be mechanically applied. A "yes" answer to only one or two of these questions can be sufficient to establish a company’s right to control.

For example, the IRS determined that workers who performed litho-stripping services for a printing firm were employees of the firm. The firm had argued that the workers were not employees because they worked in their own homes and were paid only for work completed. The IRS was not persuaded by the argument. The IRS noted that since the workers were given their materials by the firm and performed the services in accordance with the firm’s specifications, the firm had the right to control the manner and means of the work. Consequently, the IRS said that the workers were employees.

Given the very serious consequences for noncompliance, employers should carefully review all of the circumstances surrounding the use of a worker in determining who is and who isn’t an employee.