January 7, 2010Client Alert

Incorporation Not a Substantive Factor In Determining Worker Status

Independent contractor misclassification is a significant problem for businesses. Businesses with employees misclassified as independent contractors face multiple risks, including wage & hour litigation and individual or class claim for benefits, as well as potential penalties for failure to withhold taxes. There always has been, and continues to be, significant risk in misclassifying independent contractors. This risk has accelerated as state and federal government entities have added progressively more scrutiny to independent contractor classifications. In the attempt to mitigate the risk of contract workers being reclassified as their employees, businesses often ask: To what extent does a worker being incorporated affect their status as an independent contractor? Can we mitigate reclassification risk by directing workers to go incorporate?

The answer is that the fact a worker is incorporated has little or no effect at all in determining worker status. Incorporating (as an S Corp, C Corp or LLC) is a “sign” that someone is serious about being in business, and that they may be more likely to be a credible independent contractor. However, in the eyes of the IRS and other regulatory authorities, corporate status is a small factor, or no factor at all, in determining whether an individual is a true independent contractor.

Reclassification Determination: Background

Labor and taxation authorities rely on a multitude of different tests to determine whether an individual is an independent contractor or an employee. There are standards under state worker’s compensation and unemployment compensation laws, the Fair Labor Standards Act, ERISA, state and federal fair employment laws, the National Labor Relations Act, and the IRS guidelines, just to name a few.

Historically, the IRS used what was called a “20 factor” test to make the determination as to whether a worker was an independent contractor. This test was revised in 2006 and the 20 factors were consolidated into three main groups, each with subdivisions.

The first group is called behavioral control which focuses on whether the business has a right to control how the individual’s work is done. The factors that fall into this category include: type of instructions given, degree of instruction, evaluation system, and training.

The second group is financial control, which focuses on whether the business has a right to control the business aspect of the worker’s job. The factors that fall into this category include: significant investment on the part of workers in their business, having un-reimbursed expenses, the opportunity for profit or loss, whether their services are available to the market, and payment method. Certainly, incorporating a business technically allows for the opportunity for profit or loss; however, this is just one of many factors which may influence an auditor’s determination. Someone who is incorporated might, or might not, have opportunity for profit or loss; might or might not have significant business expenses; and might or might not have multiple clients.

The third and final category is titled type of relationship, which focuses on the relationship that exists between the worker and the business. Here, the factors include the following categories: the existence of written contracts, whether the worker is offered employee benefits, the permanency of the relationship, and whether their worker’s services are seen as a key activity of the business.


It is a commonly held myth that workers operating through a corporate structure (as a corporation or as an LLC) are guaranteed independent contractor status. However, nothing within the IRS analysis indicates that incorporation alone is sufficient to create an independent contractor relationship, or that incorporation is a factor, at all, in the mitigation of reclassification risk. Published IRS guidance indicates that businesses must weigh all of these factors when determining whether a worker is an employee or independent contractor. The IRS says, “there is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination. ”

Further, state taxation authorities and regulatory bodies also do not consider incorporation status as dispositive in making determinations relative to coverage under wage and hour laws, payment of unemployment tax, coverage under workers compensation, access to Family Medical Leave, fair employment laws, and a host of other potential benefits afforded employees under the individual state (and in some cases local) statutes.

Incorporating is not useless, and is not without benefit for putative independent contractors. But it would be a serious error to take action based on the belief that a group of workers are without risk of reclassification simply because they are incorporated, especially if they incorporated, or were directed to become incorporated, by the party paying them in a bid to mitigate the risk of reclassification.
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