Hiring an independent contractor offers employers many advantages. Unlike for traditional employees, employers do not pay taxes on independent contractors’ wages, and are not expected to provide benefits. Employers often save 30 to 40 percent on labor costs by using independent contractors. In addition, as independent contractors are generally hired for a specific period or project, employers have no obligation to rehire them after each contract period or project is complete.
Employers should be cautious when classifying individuals as independent contractors. Misclassifying an employee as an independent contractor can have serious financial and legal consequences.
At the end of each year, the Internal Revenue Service (IRS) requires employers to issue Form 1099 to every contractor to whom they paid $600 or more during the tax year and file Form 1096 with the IRS to report payments the employer made to contractors.
The IRS, the U.S. Department of Labor and various state agencies constantly monitor compliance with employee and independent contractor classification using a variety of criteria. Using the Employment Tax Examination Program (ETE), special IRS teams investigate misclassification of workers through audits. Employers that file Form 1099 are subject to audits, as are employers in industries that tend to abuse the privilege of hiring independent contractors.
If a company is found in violation, the IRS may impose the following penalties in addition to attorney and tax advisor’s fees:
As a general rule, the more an employer controls the work of an individual, the more likely that individual is the employer’s employee. For this reason, it is generally accepted that employers can control or direct the result of the work done by independent contractors, but not the means and methods by which contractors choose to accomplish each assignment.
In addition, employers do not supervise a contractor’s work as they would monitor an employee’s performance, nor do they usually provide the supplies or tools the contractor needs to complete its tasks.
In contrast, employers can exercise a higher degree of control on their employees. This includes not only the jobs employees perform but also the processes and tools they must use to complete them.
There are also compensation differences between the employer-contractor relationship and the employer-employee relationship. A contractor’s claim for compensation is tied to its ability to meet the expectations of its contract. It is possible for an employer to refuse compensation to a contractor that fails to deliver the services it was hired to provide. On the other hand, an employer’s ability to refuse paying employee wages is limited and often illegal.
Nevertheless, there are some exceptions to the general rule regarding degree of control.
Statutory employees are workers who, by statute, must be classified as employees, even when their work relationship with an employer looks more like that of an independent contractor. For FICA and FUTA purposes, a worker is classified as an employee if he or she belongs to one of the categories below and meets the criteria for withholding Social Security and Medicare taxes:
There are three categories of statutory non-employees: direct sellers, licensed real estate agents and certain companion sitters. These individuals are treated as self-employed for federal tax purposes if:
Misclassifying employees as independent contractors is potentially a serious liability for employers. Typically, misclassifying an employee can expose employers to federal sanctions and investigations, state audits and penalties, and unexpected unemployment and workers’ compensation lawsuits.
The IRS uses a version of the common law control test to determine whether an individual is an employee or an independent contractor. If the majority of the factors in the control test favor the existence of an employer-employee relationship, then the individual should be classified as an employee (or vice versa).
Since common law factors change, the courts and the IRS have grouped the preceding questions into three main categories, known as the “categories of evidence.” These categories are behavioral control, financial control and type of relationship.
Behavioral Control – Individuals should be classified as employees if the employer assumes control over their instruction and training:
Financial Control – The extent to which the individual carries the following financial burdens or privileges can dictate whether he or she is an employee or an independent contractor:
Type of Relationship – The following can also be used to classify an individual:
Beginning on 2015, the IRS adopted a simplified 11-point test that looks at the 11 factors outlined by the categories of evidence described above.
Other government agencies, including state agencies, have developed their own systems to determine an individual’s status within a company. Employers should contact these agencies directly for specific information.
The Supreme Court has ruled that the common law test also determines whether an individual is considered an employee for the purpose of the Employee Retirement Income Security Act of 1974 (ERISA), stating that it would consider the following in determining if someone is eligible for retirement benefits:
Under the Fair Labor Standards Act (FLSA), the federal courts apply a six-point test to determine whether an individual is considered an employee or an independent contractor. This test also focuses on how much control an employer has over an individual. Under the FLSA, federal courts consider the following:
The National Labor Relations Act (NLRA) specifically excludes contracted persons as employees. As a result the National Labor Relations Board (NLRB) also developed several determinants to decide whether an individual is considered an employee or an independent contractor. The NLRB’s determinants focus on whether the employer has the right to control and provide direction for the work completed by asking:
Companies wishing to hire an independent contractor should be aware of common mistakes in order to avoid potential penalties. An independent contractor agreement is a good first step. This document should contain a description of the services the individual will perform, how long the task should take and how the person will be paid. This agreement can serve as evidence of the person’s intended status with the employer should an investigation ever arise.
It is also wise to screen independent contractors before hiring them to complete a project. It’s best to develop a formal interview questionnaire to obtain the information needed to prove the person’s status. Here are some good questions to ask:
While hiring an independent contractor provides many advantages to companies, it imperative that employers document and update records that can prove an individual’s status as an independent contractor. The pivotal detail to remember is that as the employer’s control increases, the likelihood that the individual can be classified as an independent contractor decreases. For this reason, it pays to be highly scrupulous when deciding to hire someone as an independent contractor.
Alison was born and raised in Chesterton. She attended Indiana University earning her Bachelor’s degree. Prior to joining GIS in 2016 Alison spent nearly 10 years in banking helping clients with banking, investments, business and loans. She has been a member of the Chesterton-Porter Rotary club and a Duneland Chamber Ambassador since 2016 and a volunteer with Porter County Court Appointed Special Advocates (CASA) since 2015. In Alison’s spare time she enjoys spending time with friends and family, beach days and musical performances.