The Department audited my construction business and reclassified my independent contractors as employees, hitting me with a withholding tax assessment -- what factors actually decide whether my workers are really independent contractors?

Plain-English summary

This ruling is a taxpayer win and a genuinely useful roadmap for any Virginia business that classifies workers as independent contractors: it walks through the Department's full three-category test, factor by factor, and shows exactly what evidence tipped the outcome.

A Virginia deck construction and repair business was audited for nearly six years (April 2014 through December 2019). The Department concluded that a number of workers the business had classified and paid as independent contractors (via Form 1099) should instead have been treated as employees, and assessed withholding tax accordingly. The business appealed, arguing the workers really were independent contractors.

For withholding tax purposes, Virginia adopts the IRS's common-law control test, organized into three categories of evidence. Behavioral control asks whether the business has the right to direct HOW the work gets done -- here, the business gave workers only project plans and materials, provided no training, and let workers use their own tools, decide their own methods, and even bring their own helpers, with no on-site supervision. Financial control looks at who bears the business risk -- here, workers were generally paid a flat amount per project (not hourly, except sometimes before 2016 when reliable labor was scarce), received no reimbursement for expenses, supplied their own often-substantial tool investment, and were free to and did seek work from other contractors (two even advertised their services online). The type of relationship examines contracts, benefits, and permanency -- here there were no written contracts, no employee benefits, engagements were per-project rather than ongoing, and the business issued 1099s reflecting its own view of the workers as contractors.

Weighing all three categories together, the Department found the business had properly classified its workers as independent contractors and abated the entire withholding tax assessment.

What this means for you

Any business that classifies workers as independent contractors

This ruling is a practical checklist. Strengthen your position on each of the three fronts: let contractors use their own methods and tools without your direction or training (behavioral control); pay per-project rather than by the hour, don't reimburse expenses, and don't require exclusivity (financial control); and skip formal benefits, keep engagements project-based rather than ongoing, and use 1099s consistently (relationship type).

Businesses currently being audited for worker classification

Gather documentation proactively for all three categories -- written testimonials from the workers themselves or from management can matter as much as formal contracts, and evidence that workers marketed their services to OTHER businesses (not just yours) is a strong financial-control factor in your favor.

Accountants and tax professionals advising contractor-heavy industries (construction, trades, gig work)

This is a clean, fact-rich application of the IRS's three-category test (citing Rev. Rul. 87-41's 20-factor framework and IRS Publication 15-A) specifically in the Virginia withholding-tax context, worth keeping on hand for construction and trade clients.

Common questions

Q: What test does Virginia use to decide if my workers are employees or independent contractors?
A: The same common-law control test the IRS uses, organized into three categories: behavioral control (who directs how the work is done), financial control (who bears the financial risk), and the type of relationship (contracts, benefits, permanency).

Q: Does it matter if I sometimes paid workers hourly instead of per-project?
A: It's one factor among many, not automatically disqualifying. Here, the Department still found independent contractor status even though the business had paid some workers hourly in earlier years, because the overall weight of the evidence favored contractor status.

Q: What evidence helped this business win its appeal?
A: No training or on-site supervision, workers using their own tools and methods, per-project (not hourly) pay with no expense reimbursement, no written contracts or benefits, consistent use of 1099s, and evidence that some workers marketed their services to other contractors as well.

Citations and references

• Va. Code § 58.1-460 (employee defined for Virginia withholding tax purposes)
• Title 23 VAC 10-140-10 (employer/employee vs. independent contractor determined under Treas. Reg. § 31.3401(c)-1)
• Treas. Reg. § 31.3121(d)-1; IRC § 3121(d)(2) (IRS common-law factors: behavioral control, financial control, relationship type)
• Rev. Rul. 87-41 (20-factor worker classification test); IRS Publication 15-A (explains the three-category framework)
• Va. Code § 58.1-205 (a Department tax assessment is deemed prima facie correct)
• P.D. 21-56 (5/4/2021) (Department's adoption of the common-law analysis for worker classification)

Subject

Administration : Audit - Evaluation of Factors

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-39

Original ruling text

March 8, 2022

Re: § 58.1-1821 Application: Withholding Tax

Dear *:

This will respond to your letter in which you seek correction of the withholding tax assessments issued to * (the “Taxpayer”) for the taxable periods April 2014 through December 2019. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer operated a deck construction and repair business in Virginia. The Department audited the Taxpayer for the periods April 2014 through December 2019. The Department concluded that a number of the Taxpayer’s workers who were classified as independent contractors should have been classified as employees. As a result, assessments were issued for withholding tax due. The Taxpayer appealed the assessments, contending the workers in question were independent contractors.

DETERMINATION

Employee Defined

Virginia Code § 58.1-460 defines “employee” as “an individual, whether a resident or a nonresident of the Commonwealth, who performs or performed any service in the Commonwealth for wages . . . .” The Code of Virginia does not define “independent contractor” for income tax withholding purposes. Under Title 23 of the Virginia Administrative Code (VAC) 10-140-10, the relationship between an employer and employee or independent contractor is determined in accordance with the test set forth in Treas. Reg. § 31.3401(c)-1. That regulation generally provides that “an employee is subject to the will and control of the employer not only as to what shall be done but how it will be done.”

In Public Document (P.D.) 21-56 (5/4/2021), the Department adopted the common-law analysis to determine whether an individual is an employee or an independent contractor. Consistent with the Internal Revenue Service (IRS), the Department will consider all information regarding the relationship between the worker and the business that provides evidence of the degree of control and the degree of independence that existed. See Internal Revenue Code (IRC) § 3121(d)(2) and Treas. Reg. § 31.3121(d)-1. In IRS Publication 15-A, the IRS explains that facts providing this evidence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. In making such a determination, the Department will examine all evidence regarding a worker’s classification, including, but not limited to, any contracts that existed between the taxpayer and the individuals in question, and written or oral testimonials from individuals with knowledge of the relationships, including members of management or the individuals themselves. Such evidence may also include the types of documents used to evidence worker classification under the 20 factor test enumerated in Rev. Rul. 87-41.

Behavioral Control

Under this test, a determination must be made as to whether the business has the right to direct and control how the worker does the task for which he was hired. This requires an examination of the instructions given to the worker and the training provided by the business. An employee generally must follow instructions given by the business regarding, among other things, when and where to work, what tools or equipment to use, what workers to hire or assist him with the work, where to purchase supplies and services, and what order to follow in performing the work. Because the amount of instruction needed may vary according to the complexity of the work and the skill of the worker, it is not required that the business actually give instructions, but rather that the business retains the right to issue such instructions. Further, providing training to the worker regarding how to perform a task in a particular manner would be indicative of an employee relationship. An independent contractor would typically use his own methods for performing tasks.

According to the Taxpayer, he provided the project plans and building materials to his workers and the workers completed the job with no further direction from him. The workers provided their own tools, decided how to complete the work and were not supervised on-site by the Taxpayer. The workers were also free to retain their own assistants. In addition, the Taxpayer did not provide any training to the workers.

Financial Control

To evaluate this test, the extent to which a business controls the business aspects of the worker’s job must be analyzed. This involves looking at the extent to which the worker has unreimbursed business expenses, the extent of the worker’s investment, and the extent to which the worker makes his services available to others. In addition, how the business pays the worker and whether the worker can realize a profit or loss are other factors to consider.

According to the Taxpayer, the workers were generally paid a fixed amount per project upon completion of the job, although they sometimes received progress payments for longer jobs. The Taxpayer, however, admits that prior to 2016 he sometimes paid the workers on an hourly basis because it was difficult to find reliable workers and he wanted to ensure timely, quality work. The Taxpayer, however, states that he did not reimburse workers for any expenses they incurred on projects. The workers also were required to provide their own tools which can amount to a significant investment in the construction industry. Further, the workers did not have an exclusive relationship with the Taxpayer and were free to seek and accept construction projects either on their own or from other contractors. The Taxpayer submitted documentation to show that two of the workers had an internet presence where they independently advertised for construction work.

Type of Relationship

The analysis of a business’s relationship with a worker includes examining any written contracts describing the parties’ intent and whether the worker is provided typical employee benefits such as health care, vacation and pension plans. In addition, the permanency of the relationship and the extent to which the worker’s services are a key aspect of the regular activities of the business can be indicative of the type of relationship between the parties.

The Taxpayer did not have a written contract with any of the workers and the workers did not work for the Taxpayer on an ongoing basis. Rather they were engaged orally for a particular project. The Taxpayer also did not provide the workers any benefits and provided them with Forms 1099 each year indicating that he viewed the workers as independent contractors rather than employees.

CONCLUSION

Under the provisions of Virginia Code § 58.1-205, an assessment of a tax by the Department is deemed prima facie correct. As such, the burden of proof is on the Taxpayer to show the Department’s assessment is incorrect. The Department’s regulations, however, require an evaluation of a business’s records to determine if its workers are employees or independent contractors pursuant to the factors enumerated in Treas. Reg. § 31.3121(d)-1 and as further described in Rev. Rul. 87-41 and more recently in IRS Publication 15-A.

After a careful review of the documentation and written testimonial provided by the Taxpayer, I have determined that the Taxpayer properly characterized the workers as independent contractors. Accordingly, the assessments will be abated.

The Code of Virginia sections, regulation and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3544.X

Related Documents

21-56