In addition to employees, your business may engage independent contractors to handle certain tasks. Determining who is an employee and who is an independent contractor is not always as easy as it sounds. Moreover, misclassifying an independent contractor as an employee can have grave repercussions for your business. You may need to pay taxes, interest, and penalties to the IRS or a state agency, even if the misclassification was inadvertent.
Independent contractors retain control over how their work is done and usually run their own separate business. They might include painters, lawyers, IT consultants, and other people in specialized fields whom you might not need to keep permanently on your staff but only retain from time to time.
Why Hire an Independent Contractor?
Employees are entitled to certain benefits, such as workers’ compensation and Social Security contributions, and many employers commit to providing a wide range of other benefits that are not technically required. Independent contractors are not entitled to these benefits. They do not need office space, and it may be easier to end the relationship if needed. Independent contractors also do not pose the same liability risks. An independent contractor cannot sue a business that contracts with them for violations of labor and employment laws, nor will the business be on the hook for accidents caused by the contractor.
On the other hand, you will not have as much control over an independent contractor as you would over an employee. Since they are running their own for-profit business, they may charge you more than you would need to pay an employee to handle the same tasks. Some individuals prefer independent contractor status, while others prefer to be employees.
No clear legal standard exists for drawing the line between an employee and an independent contractor, but the IRS provides some guidance. Some situations in which a worker is clearly an independent contractor include when they have a separate place of business, they buy their own materials and hire their own assistants, they offer the same services to many different businesses, and they determine their economic fate. In other words, whether they earn a profit or absorb a loss depends on them rather than the business contracting with them.
Unfortunately for business owners, many relationships involve some factors that point toward employee status and other factors that point toward independent contractor status. When this happens, you can decide to simply treat the individual as an employee, which removes any risk of penalties down the road. This may impose greater costs than necessary on your business, since the individual will receive benefits that they may or may not be owed. Some independent contractors also will be reluctant to be treated as an employee because they prefer the advantages of independent contractor status. Alternatively, you can require a worker in an ambiguous position to form their own business, for which they will work as an employee. This will make clear that they are an independent contractor for IRS purposes.
Accepting the Risk
If you decide that neither of these options works well in your situation, you can simply hire the worker as an independent contractor and accept the risk that comes with that step. One way to limit the risk is to sign a contract with them that outlines their responsibilities and gives them substantial control over their work. You can require the contractor to use their own equipment and carry their own insurance, and you should pay them in a lump sum rather than periodically. Refraining from paying them for business expenses and withholding benefits can be critical. You can keep documentation of the worker’s independent status, such as their Employer Identification Number and business card.