Third party relationships have become more important as companies look to leverage outside expertise. As relationships evolve, management needs to keep a close eye to determine if the third party contractor has become an employee through the eyes of the IRS. The IRS provides guidance through Topic 762 (see below).

As discussed below, criteria exists to evaluate the contractor relationships; this area has drawn a lot of attention from the IRS. Companies should use caution in drafting service agreements — how much control a company has will go a long way in supporting the conclusion. The more autonomy a contractor can demonstrate in how he/she works will help support the contractor conclusion.

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Topic 762: Independent Contractor vs. Employee

For federal employment tax purposes, the usual common law rules are applicable to determine if a worker is an independent contractor or an employee. Under the common law, you must examine the relationship between the worker and the business. You should consider all evidence of the degree of control and independence in this relationship. The facts that provide this evidence fall into three categories: behavioral control, financial control, and the relationship of the parties.

Behavioral control covers facts that show if the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training, or other means.

Financial control covers facts that show if the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:

  • The extent to which the worker has unreimbursed business expenses
  • The extent of the worker’s investment in the facilities or tools used in performing services
  • The extent to which the worker makes his or her services available to the relevant market
  • How the business pays the worker
  • The extent to which the worker can realize a profit or incur a loss

Relationship of the parties covers facts that show the type of relationship the parties had. This includes:

  • Written contracts describing the relationship the parties intended to create
  • Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay
  • The permanency of the relationship
  • The extent to which services performed by the worker are a key aspect of the regular business of the company


Contact your Dean Dorton advisor or Gina Whitis at to learn more.