What You Must Know about Hiring Independent Contractors

If your business uses independent contractors, the best tax advice is simple: Watch your back! Why?  Because state governments are lining up to help the IRS nab businesses they believe have misclassified workers as independent contractors instead of employees.

In tax terms, the difference is huge. If the IRS says you did it wrong, the taxes and penalties will do some serious damage.  And states now want their pound of flesh as well.  Pennsylvania, for example, just enacted a law that can impose civil and even criminal penalties on businesses that misclassify workers. Other states with similar laws include CO, CT, DE, IL, MD, MA, NE, NJ, NM, NY and WI.  Others won’t be far behind.

And be aware that the IRS uses leads and other information it gets from all states to identify and audit small businesses it feels are misclassifying workers.  In short, small business is a big target, and thousands of audits are underway already, with thousands more to come.

Using independent contractors or “contract workers” properly has long been one of the stickiest issues that small business owners face.  Are the people you bring in to provide specific services “independent contractors” (non-employees)? Or are they actually employees?

Because independent contractors are responsible for paying their own taxes, using them can save your business a bundle in payroll taxes, insurance, benefit costs, training and other areas. Independent contractors work for themselves. They operate their own business and have you as a client. You are not their employer and don’t set their hours or control how they perform their work.

But the IRS sees it this way: A worker is an employee of your business unless you can prove otherwise.  “Determining whether a new worker is an employee or an independent contractor can be tough,” says Keith Hall, National Tax Advisor for the National Association for the Self-Employed (NASE).  “Keep in mind that you can’t just choose which one is easiest.  It really depends on who calls the shots day to day.”

If you’re unsure how to classify a worker, here’s quick advice from NASE:

  • If you control the Who, Where, When and How the work is done, they are probably an employee. This means that you, as the business owner, must file a Form W-2 and withhold income and payroll tax, among other things.
  • If the worker controls their own work product and even has other customers besides you, then they are most likely independent contractors.  Payments to independent contractors are reported on IRS Form 1099, and the independent contractors are responsible for their taxes and their own tax forms, including Schedule C, Profit or Loss from Business and Schedule SE, Self Employment Tax.

And also know that workers who believe they’ve been improperly classified as independent contractors can file an Uncollected Social Security and Medicare Tax on Wages form asking the IRS to calculate and collect the employer portion of those two items that would have been due from you.

Here are 12 other things you should do and know:

  1. Using an independent contractor agreement can help (a little): A simple agreement that specifies the independent contractor relationship can help validate your position, but it won’t be enough by itself. Sample independent contractor agreements that you can use or adapt for your own business are available online at Business Owner’s Toolkit and DocStoc.com.
  2. Know the rules for your specific business or industry: Some industries or types of businesses have established a tradition of using independent contractors rather than employees and have cleared this with taxing authorities. But at the same time, firms in certain lines of business are at high risk for aggressive worker “reclassification” audits – especially construction and landscaping.  IRS Publication 15-A, The Employer’s Supplemental Tax Guide (PDF) has detailed guidance including information for specific industries.
  3. The Independent Contractor Report, which has been tracking legal issues in this area since 1986, has detailed information on industries most at risk.   
  4. Know what the IRS says: This is an area where’s it’s important for business to look at what the IRS is saying about the business relationship between you and the person performing the services. The links below have what you need.
  5. Contractors control when and where they work. While they might receive job specifications from a client, they are not given specific instruction on how to accomplish a task.
  6. Avoid setting a pattern of daily or weekly work hours dictated by your business.
  7. Contractors do not usually have a permanent or continuing relationship with your business and have time to pursue other clients. Compensate contractors on a per-job basis, rather than weekly or monthly.
  8. Contractors are paid to complete a set task and may bring in others to complete it, at their discretion and on their payroll.
  9. Contractors use their own tools and technology and are responsible for their incremental expenses. They have an investment in their own “business” and should be able to perform their duties without your facilities.
  10. Contractors can’t be fired as long as they produce results that meet their contract specifications.
  11. Contractors are not covered under health insurance or other benefits you have for employees.  They should have their own.
  12. Legal self-help publisher Nolo has a great guidebook that shows you how to: create a valid contract, assess who qualifies as an independent contractor, hire ICs without risking an audit, retain ownership of intellectual property when using ICs and take advantage of the IRS “Safe Harbor” law.  Details at Nolo.

These IRS resources will also help:

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About the Author:

Daniel Kehrer, Founder and Chief Content Officer of BizBest Media, is a senior-level leader in digital media, content development and online marketing with special expertise in startups, SMB, social media and generating traffic, engagement and leads. He holds an MBA from UCLA/Anderson and is a passionate entrepreneur (started 4 businesses), syndicated columnist, blogger, thought leader and author of 7 business and financial books.

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