ARTICLE OF THE MONTH as published in the September 1997 issue of the LawResearch Newsletter for Legal Professionals on the Internet - Employee vs Independent Contractor. This article provides the rules for classification of workers, relative to employees of software and Internet companies work in an industry characterized by companies that can grow rapidly or can disappear overnight. There are many relevant similarities to the status of taxi drivers.

Employee vs Independent Contractor

Employees of software and Internet companies work in an industry characterized by companies that can grow rapidly or can disappear overnight.  Employees of these companies are usually highly skilled and highly mobile.  The classification of part time or temporary workers can be difficult.   Are they employees, or are they independent contractors?  Many big companies have paid the price for missclassifying workers.  This chapter provides the rules for classification of workers.

This is a chapter from the book, "Taxation of Software and Internet Companies", by David Hardesty. This book will be available soon for $39.99. Anyone interested in purchasing the book can call the author at (415) 925-1120 ext 104, or e-mail to

David Hardesty, CPA, MBA (Tax)
Copyright, David Hardesty, 1997. All rights reserved.

Employee vs independent contractors
Determination of employee status - IRS rules
Common law standard for worker classification
Twenty factors from Revenue Ruling 87-41
Technical services providers
Section 530 safe harbor
The Microsoft case


Software companies often expand their workforces to meet project deadlines, and contract workforces when the projects are finished. There has been a reluctance on the part of some software companies to take on temporary workers as "employees". Where workers are taken on for specific projects, some companies have preferred to characterize these workers as "independent contractors". For larger companies, the aim was to avoid having to provide employee benefits to these temporary workers, even if temporary meant periods lasting a year or more. For many smaller companies that did not provide benefits, use of "independent contractors" meant avoiding paperwork involved in bringing on new employees.

Workers, too, can be reluctant to be characterized as employees. A worker who maintains an office at home, has unreimbursed business expenses, or has a self-employed retirement plan loses valuable deductions when characterized as an employee.

Another characteristic of employment in software and Internet companies is the use of stock options. Rapidly growing companies are always cash poor and may prefer to reward employees with stock options rather than cash. The taxation of options is a bewildering environment that includes non-qualified options, four types of qualified options, and different rules for regular and alternative minimum tax. The use of different strategies for exercising these options can save the employee substantial taxes.

Employee vs independent contractors

Temporary workers are common in the software industry. A software developer often needs to hire someone with specialized expertise for a short period of time. The temporary worker may be a programmer, an artist, or even an actor. The question always comes up as to whether this person is an employee or an independent contractor.

Failure to properly characterize a temporary worker can have serious tax consequences. In the worst case the employer can end up paying that person's income tax, plus payroll taxes, plus substantial penalties and interest. If an employer has a pension or profit sharing plan, or a 401(k) plan, failure to cover temporary workers who are actually employees can invalidate the plan. The employee can lose deductions for a home office, for unreimbursed business expenses, and for payments to a self-employed retirement plan.

The employer is usually in a tough position. Most temporary workers do not want to be treated as employees (until they apply for unemployment insurance, that is). The position the employer takes can alienate valuable workers. The employer must therefore know how to determine who is and who is not an employee.

The employer can take some steps to protect itself.

For every potential independent contractor determine if the worker is covered by the Section 530 safe harbor explained below. The employer should make sure that its compliance with Section 530 is fully documented. Remember, however, that Section 530 only protects the employer. The worker can still be reclassified as an employee and lose valuable deductions.

The employer should look at the common law rules regarding characterization as an employee or independent contractor. These rules are summarized in IRS Revenue Ruling 87-41, discussed below. Remember that the rules are guides only. Their purpose is to get at the degree to which the business has the right to direct and control the work.

The company and the contractor should have a written contract.

If possible use independent contractors who are incorporated. This is often not practical, and there is no guarantee that it will work. But, it is helpful.

Determination of employee status - IRS rules

The determination of whether an individual is an employee or an independent contractor is based upon the relationship of the worker and the employer. The determination is based on common law. Common law in this area has it source in court decisions. The employment tax regulations, which are based on common law standards, provide that an employer/employee relationship exists if the business has the right to direct and control the work.

The IRS and Social Security Administration have compiled over the years a list of twenty factors that have been used in court decisions to determine a worker's status. These factors are set out in Revenue Ruling 87-41. The twenty factors are a way to analyze the degree to which the business has a right to direct and control the worker.

A safe harbor exists that companies can use to categorize workers. Section 530 is a non-code section that allows companies to treat workers as independent contractors even if they are considered employees under a common law standard. This section only applies to the employer. A worker who is an employee based on a common law standard remains an employee even if the company is allowed to treat the worker as an independent contractor.

Section 530 is helpful to the company because it adds some certainty to the company's treatment of workers. The worker, however, is left with a considerable amount of uncertainty. The worker is still apt to be reclassified as an employee. The effect of being reclassified is the possible loss of unreimbursed business deductions, home office deductions, and deductions for contributions to self-employed retirement plans.

The discussion here first focuses on the common law standard for determnining a worker's status. The common law standard is the most important consideration because it applies to both the company and the worker. Next we look at Section 530. Section 530 can be used to limit the damage caused by a misclassification of workers.

Common law standard for worker classification

The Internal Revenue Service says "an individual is an employee for federal employment tax purposes if the individual has the status of an employee under the usual common law rules applicable in determining the employer-employee relationship". An individual is an employee "when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but as to how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so." (1) The Service’s analysis is based on rules set out in Employment Tax Regulations, (2) and its analysis of court decisions.

Revenue Ruling 87-41 sets out twenty factors that can be used as a guide to determining if an individual is an employee under common law rules. The twenty factors are never given equal weight. Depending on the business relationship, some are given additional weight and some are given no weight at all. For instance, one factor is training. The fact that a business trains a worker is given extra weight if a worker must be trained by the company before the worker can do a job. However, consider a software company that only hires fully trained software engineers. The company provides no training at all, regardless of whether an engineer is an employee or independent contractor. Because no training is required in either case, the fact that the company does not train is given no weight in determining the status of the engineer.

No single factor among the twenty factors determinative. The factors are meant to provide a full description of the relationship so that a decision can be made as to the degree to which a company has the right to direct and control the worker. Remember, the right to direct and control is the key to the determination of status.

In general, "no" answers to questions 1 to 16 and "yes" answers to questions 17 to 20 indicate an independent contractor. However, a simple majority of "no" answers to questions 1 to 16 and "yes" answers to questions 17 to 20 does not guarantee independent contractor treatment. Some questions are either irrevelant or of less importance because the answers may apply equally to employees and independent contractors. For instance, question 9 asks whether work is performed on the employer's premises. Maintenance of a company's computers must be done company premises because that is where the computers are. The determination of whether the person providing the maintenance is an employee must be done using other factors.

Twenty factors from Revenue Ruling 87-41

  1. Is the worker required to follow company instructions as to when, where, and how he or she is to work? This is a key factor concerning the company's right to direct and control the work.

  2. Does the company provide training? This is an important factor if the worker needs training. Training is a way of directing and controling work. If the worker comes fully trained, or if no training is required, this factor may have no importance.

  3. Are the worker’s services closely integrated with the business? For instance, a receptionist is closely integrated with the business, while a janitorial service is not.

  4. Does the worker have to personally render the services, or can the worker subcontract out the work? The worker's ability to hire assistants or subcontract the work is an important indicator of an independent contractor.

  5. Does the company hire, supervise, and pay assistants to the worker?

  6. Is there a continuing relationship between the company and the worker where work is performed at frequently recurring intervals?

  7. Does the company set the work hours?

  8. Must the worker devote substantially full time to the company? This factor is highly dependent on the facts. For instance, an independent contractor may work exclusively for one company on a project lasting a year or more.

  9. Does the worker perform services on the company's premises? This factor is of less importance if the work can only be done on company premises, for example maintenance services

  10. Must the worker perform services in the order or sequence set by the company? This indicate employee status. However, in some situations work must be done in a sequence so that it is coordinated with the efforts of company employees or other contractors.

  11. Must the worker submit oral or written reports to the company? This is an important indicator if the submission of reports is integral to the company's control of the worker. However, many consultants who are independent contractors submit reports to companies with the company having no direct control over the consultants.

  12. Is the worker paid by the hour, week, or month? Payment of a flat fee versus payment by the hour, week or month, is indicative of an independent contractor. However, some professions normally bill by the hour. These in accountants, consultants, lawyers, etc.

  13. Does the company pay the business or traveling expenses of the worker? Many consultants require the client to pay travel and lodging expenses. What is important here is to look at expenses that are not reimbursed. Independent contractor are more likely to have unreimbursed business expenses.

  14. Does the company furnish significant tools, materials and equipment? There is an indication of an independent contractor where a worker that uses his or her own equipment.

  15. Does the company have the right to fire the worker? The right to fire a worker without liability provides an effective means to control a worker, and can indicate an employee relationship. However, in today's companies have far less flexibility in firing a worker than in the past. The inability of a company to fire a worker is not necessarily indicative of an independent contractor.

  16. Can the worker quit without incurring a liability to the company? A worker's ability to quit without liability to the company may indicate an employee relationship. However, certain professionals rendering personal services can usually terminate a relationship without penalty. In addition, a company can conceivably sue an employee for nonperformance.

  17. Does the worker have a significant investment in tools or facilities? A worker with significant investment in tools or facilities is in a position to exercise considerable control over the use of the tools in the performance of the work. This indicates an independent contractor.

  18. Can the worker realize a profit or loss as a result of his or her services? A worker who is incurring substantial expenses in tools, facilities and operating expenses will exercise substantial control over the way in which money is spent. This indicates an independent contractor.

  19. Does the worker provide substantial services to multiple companies at one time? This factor is of less importance than the others. A temporary worker may be employed by different companies every week, and be under the direction and control of each of those companies. Whereas, an independent contractor may work exclusively for one company on a project that lasts a year or more.

  20. Does the worker regularly advertise or make his or her services available to the general public? This is an indicator or an independent contractor. However, the failure to advertise does not indicate an employee. Many consultants never advertise, relying ob word-of-mouth.

Technical services providers

Revenue Ruling 87-41 provides examples of the application of direction and control factors to technical services providers. In this case, technical services providers are companies that provide technical people to software companies for temporary assignments. The IRS described three different situations, and analyzed those situations using the 20 factors discussed above.

In this ruling companies provide technical people to software companies for temporary assignments. The Firm providing the personnel many times desires for the personnel to be employees of the Firm. The Service has presented three scenarios regarding the provision of such services, and the Service’s opinion as to the outcome.

In the following three situations (adapted from Revenue Ruling 87-41), a Firm provides temporary technical services to its clients. The Firm contracts with a Client to provide the services of an Individual who is a computer programmer for a project which is expected to last less than one year. The Firm does not train its workers.

Situation 1

  1. The Individual works for the Client substantially full-time.

  2. A significant portion of the services are performed on the Client's premises.

  3. The Individual reports to the Firm on time worked and describes the progress of the work.

  4. The Firm pays the Individual and charges the Client for the services performed.

  5. The Firm reviews the Individual's work and may fire the Individual for an unsatisfactory review.

  6. The Firm will replace the Individual if the services are unacceptable to the Client. In such a case, however, the Individual will still receive his or her pay for work done.

  7. The Individual cannot perform services directly for the Client and the Client cannot receive services from the Individual for three months after the end of services by or on behalf of the Firm.

Result: In this situation, the Individual is an employee of the Firm, not the Client.

Situation 2

  1. The Individual does not work for the Client full-time. The Individual performs substantial services for other persons.

  2. Some services are performed on the Client's premises.

  3. The Individual does not report, directly or indirectly, to the Firm after the beginning of the assignment to the Client.

  4. The Firm does not pay the Individual.

  5. The Firm does not review the Individual's work. The Firm may not fire the Individual.

  6. The Firm is not required to replace the Individual if the services are unacceptable to the Client.

  7. Neither the Individual nor the Client is prohibited from contracting directly with each other after the contract.

  8. If the Individual stops providing services to the Client prior to completion of the project or if the work is unsatisfactory, the client may seek damages from the Individual. However, the Client may not seek damages from the Firm.

  9. The Firm receives from the Client a flat fee for its services.

  10. The Individual is performing services that can be accomplished without the Individual's receiving direction or control as to hours, place of work, sequence, or details of work.

Result: The Individual is not an employee of the Firm.

Situation 3

  1. The Individual works for the Client substantially full-time. The Individual can work for other persons during the contract, but does not do so.

  2. A significant portion of the services are performed on the Client's premises, using materials and equipment of the Client.

  3. The Individual reports to the Client on a regular basis.

  4. The Individual is paid by the Firm. However, the Firm does not have to pay the Individual if the Firm is not paid by the Client.

  5. The Firm may not direct the work of the Individual and has no responsibility for the work performed by the Individual. The Firm may not fire the Individual.

  6. The Firm will replace the Individual if the services are unacceptable to the Client. In such a case, however, the Individual will still receive his or her pay for work done.

  7. The Individual cannot perform services directly for the Client and the Client cannot receive services from the Individual for three months after the end of services by or on behalf of the Firm.

  8. The Client's employees supervise the Individual.

  9. The Firm receives a flat fee from the Client. The Firm also gets a fee for performing the payroll function.

  10. The Client can fire the Individual without liability to either the Individual or the Firm.

Result: The Individual is not an employee of the Firm.

Section 530 safe harbor

Section 530 provides a safe harbor that allows an employer some certainty with regard to the classification of workers as independent contractors. The safe harbor allows the company to treat a worker as an independent contractor, even if the worker is an employee under common law standards.

The safe harbor does not protect workers, however. If the worker is an employee under common law standards, then the worker will not be able to file a tax return as a self-employed individual. This means that unreimbursed business deductions and home office deductions will have to be taken as itemized deductions, rather than Schedule C business deductions. In addition, the worker will not be able to make contributions to a self-employed retirement plan.

Under Section 530, the company can treat a worker as an independent contractor if:

  1. For purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period.

  2. All of the taxpayer’s Federal tax returns after December 31 1978 are filed on a basis consistent with the taxpayer's treatment of such individual as not being an employee.

  3. The taxpayer had a reasonable basis for not treating the individual as an employee. A taxpayer is treated as having such a reasonable basis if the taxpayer relied on any of the following:

(A) Judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;

(B) A past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or

(C) Long-standing recognized practice of a significant segment of the industry in which such individual was engaged.

  1. The taxpayer (or a predecessor) has not treated any individual holding a substantially similar position as an employee for purposes of employment taxes.

This safe harbor does not apply in a three-party situation where a specialist provides services for a client of a technical services firm under an agreement between the firm and the client. A specialist in this case includes an individual who provides services as an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work. This provision only applies to three-party situations. A specialist providing services directly to a firm is not automatically converted to employee status. (3)

The Microsoft case

Microsoft has been involved in litigation with certain individuals performing services for Microsoft. The subject of the litigation is whether those individuals were entitle to benefits as employees of Microsoft.

Microsoft, one of the country's fastest growing and most successful corporations, and is the world's largest software company. Microsoft employs a core staff of permanent employees, known as "regular employees". In previous years its also supplemented it core staff with individuals not considered to be employees. These individuals were referred to as "independent contractors" or "freelancers". There difference between the two groups is the regular employees received substantial employee benefits, and the freelancers and independent contractors did not.

In 1989 and 1990, the Internal Revenue Service examined Microsoft's employment records and found that Microsoft's freelancers were not independent contractors but employees. Certain factors led to this determination. For instance, Microsoft fully integrated the freelancers into its workforce. They often worked on teams along with regular employees, sharing the same supervisors, performing identical functions, and working the same core hours. Microsoft required the freelancers to work on site.

There were some relatively minor distinctions between the regular employees and the others. The Freelancers wore badges of a different color, had different electronic-mail addresses, and attended a less formal orientation than that provided to regular employees. They were not permitted to assign their work to others, invited to official company functions, or paid overtime wages. In addition, they were not paid through Microsoft's payroll department. Instead, they submitted invoices for their services, documenting their hours and the projects on which they worked, and were paid through the accounts receivable department.

The freelancer were told when they were hired that, as freelancers, they would not be eligible for benefits. The Freelancers were apparently required to sign a "Microsoft Corporation Independent Contractor Copyright Assignment and Non-Disclosure Agreements" (non-disclosure agreements) as well as companion documents entitled "Independent Contractor/Freelancer Information ". The information document stated that "as an Independent Contractor to Microsoft, you are self-employed and are responsible to pay all your own insurance and benefits." (4)

The case cited above was not the case to decide whether the freelancers were employees for income tax purposes. That matter was apparently settled out of court. The subject of the cited case was a suit brought by the freelancers to get employee benefits. Their theory was that if they were employees under common law, they should get benefits available to employees. Accordingly we can only surmise, based on the information provided in the case the rational behind the decision that the freelancers were in fact employees.

Based on the information provided in the case, it is not hard to see that the minor distinctions between the regular employees and the freelancers were not significant enough to persuade the Service that the freelancers were not employees. In additional, the fact that the freelancers apparently signed some form of independent contract agreement was equally unpersuasive.

The court eventually found that the freelancers were eligible for the benefits the freelancer sought. The benefits included Microsoft's cash or deferred arrangement and stock option plan.

The lessons to learn from this case are twofold. The first is regardless of the form of the arrangement, the Service and the courts will look to the substance of an arrangement. The most carefully drafted independent contractor agreement will not protect an employer if the so-called independent contractors have employee characteristics. The second is that the penalty for having an independent contractor recharacterized as an employee can go beyond tax considerations. Independent contractors who are determined to be employees can potentially lay a major claim to additional benefits. What is significant about this case is that former freelancers laid claim to employee benefits even though on initial hire both parties understood that no benefits would be available. (5) Clearly, companies and contractors are not free to create an independent contractor relationship when the substance of the relationship is employer/employee.


1 Revenue Ruling 87-41.

2 Revenue Ruling 87-41 cites Employment Tax Regulations sections 31.3121(d)-1(c); 31.3306(i)-1; and 31.3401(c)-1.

3 ACT SEC. 530. [Revenue Act of 1978 (P.L. 95-600) as amended by P.L. 96-167, P.L. 96-541, P.L. 97-248 P.L. 99-514 and P.L. 104-188].

4 Donna Vizcaino, et al v. Microsoft Corporation, 96-2 USTC 50,533] (CA-9), U.S. Court of Appeals, 9th Circuit, 94-35770, 10/3/96, Reversing and remanding an unreported District Court decision.

5 Donna Vizcaino, et al v. Microsoft Corporation, 96-2 USTC 50,533] - Transcript of testimony contained in dissenting opinion makes it clear that freelancers knew there would be no benefits. In addition, the dissenting opinion discusses the fact that freelancers were paid more than regular employees on an hourly basis to make up for this lack of benefits.

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