Using Independent Contractors

February 24th, 2011 by Doug Boswell

Independent contractors are workers who provide their services, usually on a short-term or part-time basis. They work with multiple clients, operate out of their own workplace, have their own tools and equipment, and may have a business license or a company name.

Generally, it makes sense to consider going with an independent contractor when you don’t have enough steady work to justify a permanent position. There are three main reasons companies hire independent contractors instead of employees.

1. The task requires specialized skills that are not available in your existing staff.
2. The task is short-term, and will only take a few weeks or months to complete.
3. The workload fluctuates, so is not consistent enough to warrant creating a permanent staff position 

Unfortunately, many companies consider using an independent contractor instead of an employee because it is less expensive. Although an independent contractor can be about 20 to 30% less expensive than an employee, if this worker is determined later to be a misclassified employee, that savings will rapidly disappear.

Business owners may not realize their decision to classify a worker as an independent contractor can get them into serious trouble with the IRS, and possibly the state. Employers pay federal and state unemployment tax and worker’s compensation insurance, plus a matching share of Social Security and Medicare. In addition, employers must collect and deposit income taxes withheld, and are required to file quarterly and annual payroll tax reports. That’s a lot of work and a lot of reporting.  It’s tempting to treat workers as independent contractors to save both time and money.  The use of independent contractors, or vendors, will spare the company all these costs with only a simple 1099 form to file at the end of the year.

What will it cost you if you get caught misclassifying employees? Back taxes can add up to 40% of the independent contractor’s payment. Consider the social security tax, federal and state income tax, and the unemployment insurance you will now have to pay. And if it is determined that your vendor is actually an employee, the Tax Man will want that money from you even if the independent contractor already paid their proper taxes on the payments you made to them.

Penalties and interest will probably also apply. The IRS has broad latitude to assess penalties depending on whether a business acted with reasonable care or purposeful disregard for tax requirements. The penalties could even cause you to lose your business.

The IRS looks at three main factors to determine the relationship between a business and a worker. Behavioral Control, Financial Control and the Type of Relationship. How the worker can be classified depends on the answers to a series of questions.

Behavioral Control
Does the business control, or have the right to control, what and how the worker does their job? Do they provide instructions or training? A general rule is that a paying business has the right to control or direct the result of the work done by an independent contractor, but not the means and methods used to accomplish that result.

Financial Control
If the payer controls the business aspects of the worker’s job, then the worker is probably an employee.

Does the worker have un-reimbursed expenses? Can the worker make business decisions that would affect their profit or loss? This “risk of loss” is a key defining component of a business and not of an employee. But if the worker were paid regardless of whether the work is completed, then that would indicate an employee. Owning tools, equipment, supplies, a computer, and such, represent business expenses that an employee doesn’t normally have, and so are consistent with independent contractor status. If the paying business provides the tools, supplies, etc. needed to perform the job, then the worker is probably an employee.

How is the worker paid? Generally, employees are paid by the hour and receive pay on a specific pay-period basis.  If the worker were paid by the job when the work is completed, that would indicate an independent contractor. However, some professions do charge clients in advance and/or an hourly rate for their services, such as lawyers, bookkeepers, or accountants, so that does not automatically determine employee or independent contractor status.

Is the worker available to provide services other clients? When a worker spends 40 hours per week at one company, the IRS views the worker as an employee. A good test of a worker’s independent contract status is if they have multiple clients. The more the better.

Type of Relationship
Is there a written contract?  Are there any employee benefits, such as a pension plan, insurance, vacation pay, etc? Will the relationship continue over the long term? Is the work performed a key aspect of the business?

When considering the use of an independent contractor, evaluate all the above factors. If any of these criteria point toward the worker being an employee, then that is the classification you should most likely use. If you decide that the worker is indeed an independent contractor, realize that should you be audited, the IRS will make their determination independent of your reasoning and may still classify them as an employee, making you liable for back taxes, interest and penalties. And then your Workers Comp carrier will start in on you. It will get expensive very fast.

Still, you can maximize your chances of prevailing by making certain that your vendor is indeed a true business entity and deserving of the independent contractor status.

You should always have a proper written and signed independent contractor agreement that defines all the relationships and the duration of the work, and lists the responsibilities of each party to pay certain taxes and insurance. Of course a contract alone will not be a determining factor, but it will be a positive factor.

An independent contractor should also have all the licensing and business registrations required to provide their services. They should at least have a business license and have filed a Fictitious Business Name Statement. If they were incorporated, that would provide the best possible evidence to prove the validity of the independent contractor status (unless you have set them up as a corporation yourself). Remember, an independent contractor must be determined to not only be a business, but to be a separate business entity.

Here is a sample checklist of documents you should require from an independent contractor:

– Signed contract
– Signed W-9 form
– Copy of Fictitious Business Name Statement
– Information on how business is structured (sole proprietorship, partnership, corporation, or LLC)
– Business address and phone number
– Unemployment insurance number and Employer Identification Number (if contractor has employees)
– Copies of professional or business licenses
– Contact information for other clients
– Samples of marketing materials (ads, website info, Yellow Pages listing, etc.)
– Business card, professional stationary, invoice form, etc.
– Copies of insurance certificates

If You’re Still Uncertain About a Worker’s Status
Both employers and workers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. If you do ask for an IRS determination, keep in mind that it may take five or six months for them to respond.

You can find out more about the determination of a worker’s status as an independent contractor or an employee at the IRS website.


Leave a Reply