The Center for Ethics, Governance, & Accountability

By now, news of the changes by the IRS to its Form 990 for non-profits has surely reached many executive directors and nonprofit boards. This article will focus on an issue that is easy to inadvertently misconstrue: the classification of a worker as an independent contractor versus an employee.

Making the correct determination between whether a worker is classified as an independent contractor or an employee can be a bit tricky, which is why so many non-profits make mistakes is this specific area. In fact, in past non-profit audits, this is cited as one of the largest areas of non-compliance, resulting in millions of dollars of penalties and interest on back taxes owed by the non-profit. Although this issue is not on the new ‘hot list’ of topics the IRS will scrutinize, it is likely to continue to be an ongoing area of interest during future audits.

What is an independent contractor and how is the classification different for employees?

Per readily available information published by the IRS: “The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.”

The IRS further states:

In determining whether the person providing the service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be an independent contractor, a common law employee, a statutory employee, or a statutory non-employee.

Facts that provide evidence of the degree of control and independence fall into three categories:

1. Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work. The behavioral control factors fall into the categories of:

·         Type of instructions given

·         Degree of instruction

·         Evaluation systems

·         Training

1. Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job. The financial control factors fall into the categories of:

·         Significant investment

·         Unreimbursed expenses

·         Opportunity for profit or loss

·         Services available to the market

·         Method of payment

1. Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. The factors, for the type of relationship between two parties, generally fall into the categories of:

·         Written contracts

·         Employee benefits

·         Permanency of the relationship

·         Services provided as key activity of the businessThese rules and regulations may appear to be complicated, but reasonableness tests by a seasoned executive director, together with reading further information available on the IRS web site should enable the organization to make the correct decision.

If questions remain, the executive director should contact legal counsel, an accountant, or a seasoned consultant.

An easy example of an independent contractor that has been incorrectly classified includes: a worker that receives employee benefits, receives evaluations, is on the job for a long time, does not offer services to other employers, receives a paycheck and a W-2 instead of submitting an invoice and receiving a 1099, receives training provided to other employees in the organization, follows regular work hours, and receives daily supervision from the employer.

You can contrast this with an independent contractor that has been correctly classified and operates as follows: the work is actually a response to an RFP, with a specific scope and deadline, but for which the contractor is responsible; the contractor has several clients for whom services are being provided; does not attend employee meetings or receive any benefits; bills for his or her time through the contractor company, and received payment on those invoices and a 1099 at the end of the year.

Another good sign would be an incorporated entity, with its own FIN, making it obvious that the contractor is actually in the contracting business for the services provided.

We again point out that the IRS is the regulatory body for non-profit entities. Compliance with the laws and regulations is not optional, but neither do we believe that the typical nonprofit is adequately focused on the importance of IRS compliance. Accordingly, we continue to believe that excellence in compliance provides a tangible competitive advantage when individuals or foundations are making decisions on a nonprofit fundraising or grant request.