Independent contractors are a popular choice for business owners to fill their work force needs. True independent contractors are not treated as employees, which essentially means that payroll taxes and certain state and federal employment laws do not apply to them. It's important, however, to ensure that a worker qualifies as an independent contractor because the repercussions for incorrectly classifying workers can be severe.
Many small business owners do not have the need or the desire to hire traditional employees to work for their business. The ones that do often only do so for the essential functions of their business. But even for these businesses there are times when a work force is required. It is for these situations that using independent contractors is a great solution.
What's so advantageous about hiring independent contractors? Hiring independent contractors allows you to have a work force only when and if you need it. With independent contractors, it's possible to have personnel to work on (or off) your premises without becoming subject to payroll taxes or to many state and federal employment laws.
Traditionally the government does not favor treating workers as independent contractors, so there are several complex federal tests involved to make sure that the person actually qualifies as an independent contractor and is not an employee.
Incorrect classification of employees as independent contractors is under intense scrutiny by both the Internal Revenue Service (IRS) and the Department of Labor (DOL). This is not an area where you can hope to fly under the radar, so be sure you're correctly classifying your workers to avoid costly fines and penalties.
Many consultants advise companies to contract out any function that is not directly related to the production of the company's core products or services. For example, many white collar-type businesses contract out their building maintenance work or food service functions.Independent contractors are also particularly useful when you need a specific skill or technical knowledge for a special project that's expected to last a relatively short length of time.
If you think using independent contractors might be the right fit for your business, consider the following:
- What, exactly, is an independent contractor? Which job categories might lend themselves to such treatment?
- What are some pros and cons of using independent contractors?
- What are some tips for successfully using independent contractors?
Defining an independent contractor
Independent contractors work for themselves — they are treated as if they are running their own business. Thus, you are not the employer of an independent contractor, and you aren't liable for payroll taxes or benefits for them, nor are they protected by workers' compensation or most labor laws.Independent contractors control the performance of the work based on their experience, special license, or special education or training required for the job.
In most cases, you tell them the outlines of the project that needs to be done and the due date, and they determine how to accomplish it, on their own schedule. The independent contractor provides the knowledge, experience, and labor to perform the job or provides other individuals to perform the job contracted. Independent contractors are usually paid based on their results (i.e., a flat rate per job, or a per-unit-completed rate) rather than the time they put in.
IRS Rules. Generally speaking, for tax purposes the key question as to whether someone qualifies as an independent contractor is the degree of control you can exercise over the worker. The worker will be treated as an employee if the company has the right to determine not just what the employee does, but when, where, or how he or she does it.
The IRS has a 20-factor test that it uses to determine whether an employee is an independent contractor or an employee in disguise. The factors can carry different weights, depending on the factual situation. Generally speaking, if the worker would be considered an employee under at least 10 of the factors, you should treat him or her as an employee.
The IRS frowns on the use of independent contractors, in part because such workers are responsible for paying their own payroll taxes and it's much more difficult to make sure they're doing so.
If in doubt, look at IRS Form SS-8, which is the form used by the IRS to determine individual status for purposes of income and employment taxes.
Fair Labor Standards Act (FLSA). The Fair Labor Standards Act (FLSA) is another important federal law governing your treatment of workers. Unfortunately, it has its own definition of independent contractor that is slightly different from the IRS's definition.
In order to be truly sure that you're safe in treating workers as independent, you must meet both definitions.
Under the FLSA, independent contractors are not employees and are, therefore, not entitled to minimum wage and overtime protections. There are six factors for determining whether a worker is an employee under the FLSA, as opposed to an independent contractor:
- the degree of the alleged employer's right to control the manner in which the work is performed
- the alleged employee's opportunity for profit or loss depending upon managerial skill
- the alleged employee's investment in equipment or materials required for the work
- whether the service rendered requires special skills
- the degree of permanence of the working relationship
- whether the service rendered by the worker is an integral part of the alleged employer's business
No single factor is more important than the others in determining independent contractor status. When the issue comes up in courts, the judge must consider whether, as a matter of economic reality, a worker is dependent on the business to which a service is rendered for continued work. The greater the dependence, the more likely the worker will be found to be an employee.
Independent contractor agreements. It's extremely important to realize that having a worker sign an independent contractor agreement will not automatically create such status if the worker does not meet the requirements of the tests described above.
Although an independent contractor agreement does not create the status, when working with independent contractors, it is a good idea to develop a written contract relinquishing the right to control and specifying that the worker will not be treated as an employee for federal tax purposes. Employers should also file informational returns (1099 MISCs) for their independent contractors and comply with state laws for workers' compensation and unemployment compensation.
A contract with an independent contractor should also include terms on terminating the relationship. Because independent contractors are not employees, termination would be done according to the provisions of the contract. Since a firm and an independent contractor have a contract relationship, not an employment relationship, any misunderstandings about job performance or termination of the relationship are governed by contract law.
What is the status of workers employed by an independent contractor? Workers employed by an independent contractor are not employees of the organization which the contractor is serving — they are employees of the contractor.
Pros and cons of using independent contractors
There are numerous advantages to using independent contractors for your staffing needs, but you should be aware of the disadvantages that exist as well.
Using independent contractors offers employers significant tax and non-tax advantages. Since employers are required to pay certain benefits and taxes on behalf of their employees, the financial benefits of having a large independent contractor work force can be significant.
For example, by classifying workers as independent contractors, employers may be able to avoid responsibility under:
- the Federal Insurance Contribution Act (FICA) or Social Security tax
- the Federal Unemployment Tax Act (FUTA)
- the Consolidated Omnibus Budget Reconciliation Act (COBRA)
- workers' compensation
- retirement plans
All payroll taxes and benefits are maintained by the individual contractor, who does not participate in your company-offered benefit plans.
Also, your own exemption from many federal and state employment laws is based on how many employees you have in your work force. Independent contractors are not counted as employees. Thus, if you contract with independent contractors instead of hiring regular full-time employees, you may not be covered by some of these laws.
These laws include:
- the Americans with Disabilities Act
- the Family and Medical Leave Act
- Title VII of the Civil Rights Act of 1964
- the Age Discrimination in Employment Act
Disadvantages of independent contractors. The main disadvantage to using independents is that you must keep on top of exactly what qualifies someone as an independent contractor. If you classify someone as an independent contractor who isn't, the penalties can be extremely costly.
In addition, independent contractors, by definition, are permitted to work for a number of different companies at a time. You won't have as much control over the worker's time, efforts, and loyalty as you would with a permanent employee.
Furthermore, some contracts permit the independent contractor to substitute another individual for himself or herself on any job, so you may not even be sure who's ultimately going to do the work for you.
Finally, independent contractors make a commitment to work for you for the length of the contract, and that's it. If you like their work and want to continue the relationship, you may have to renegotiate the agreement (including their payment rate).
Tips for using independent contractors
You should be aware that there are various steps you can take to facilitate your use of independent contractors. Here are some things you can do to help ensure that those who work for you qualify for independent contractor status and that you can win any challenges to your arrangements:
- Be careful, when advertising for independent contractors, to avoid using phrases such as salary, wages, or steady work when you are recruiting. Try looking for independent contractors who have placed their own ads under "Situations Wanted" or "Trade Services."
- When establishing the relationship, avoid setting a regular pattern of daily or weekly hours. A self-employed individual presumably has the opportunity to select when and where he will work in relation to all his customers.
- Allow contractors to supply their own tools, supplies, and equipment wherever possible in the performance of the services required. This will demonstrate that there is a risk of loss as well as an opportunity for profit.
- Use contractors who normally advertise their services in some manner. Keep on file any business cards, circulars, or even telephone directory ads.
- Allow contractors to hire their own assistants, if necessary. Insist that the contractor pay the payroll taxes normally required for such employees.
- Don't include contractors under the insurance coverage for workers' compensation, health insurance, or other benefits that are provided for employees.
- If possible, compensate such independent contractors on a per-job basis rather than by hour or by week.
- Always ask for an invoice or statement before paying for any work that has been performed. If possible, make checks payable to a company rather than to an individual.
- Do not directly reimburse contractors for any expenses they might have, for gasoline, meals, etc. Such expenses should stand as part of the contractor's set fees.
- Remember that in theory you cannot discharge a contractor from employment. If dissatisfied with a contractor's performance, look to your contract for a remedy. If there is no contract, sever relations with the contractor by offering no more work.
- Put it in writing! It is best, of course, to have a contract in writing with an independent contractor. This can be used on your behalf to demonstrate the validity of an independent contractor relationship, although it isn't conclusive evidence of one.
- In many states, an agreement is required in order to establish an independent contractor relationship.
Tools to use
The Business Tools include a sample independent contractor agreement for your use.