Independent Contractors, Uncle Sam Wants You!

For many reasons, early stage startups love to hire contractors instead of employees.  Independent contractors are often cheaper, the company doesn't have to pay employment taxes, benefits, or worker's compensation insurance, HR compliance issues are simpler, and the company retains workforce flexibility.

Unfortunately, I have to remind my clients that the choice as to whether someone is an independent contractor or an employee is not necessarily up to them.

"But we're only going to hire them a few hours a week!"  Sorry, but full time vs. part time does not determine whether someone is a contractor.  They might be a part-time employee.

"But they want/have agreed to be an independent contractor!"  Sorry but willingness on the part of both parties is not a determinant either.

So who does determine whether someone is an independent contractor if not the two parties involved?  The IRS and the state.

Why?  Because the U.S. government really wants as many people as possible to be classified as employees. The reason? Take a look at this graph:

Notice that between individual income tax and payroll taxes, 81% of government income comes from employee based revenues.  Now independent contractors also pay income taxes and will pay their equivalent of payroll taxes (1040 Schedule SE) as self-employment tax.  But the amount will generally be less because of one key difference: employees earn a wage that is taxed after which expenses are paid. Self-employed individuals, on the other hand, are small businesses which earn revenue, deduct business expenses, and only then pay taxes on the net, which is most often a smaller number.  This means less taxes to the government.  (It's also one reason why only 12% of government income comes from corporate income tax.)

So what determine whether a person is an independent contractor vs. an employee?  Unfortunately, the answer is not clear cut.

The guidelines used by the U.S. Dept. of Labor, IRS, and (in California) the Employment Development Department (EDD) is whether the employer has the "right to control" a person's work whether it is exercised or not. They also look at whether the contractor can suffer the risk of loss, provides their own tools, have their own workspace, are publicly available for business with multiple clients, and the duration of the work engagement.

So how do government auditors determine this?  Largely its a judgment call.  With respect to the above factors, the more often the contractor answers "no" and if the engagement extends more than six months, the more likely the auditor is going to want to classify that person as an employee.

The IRS used to have what it was called a twenty point test, but replaced this a few years back with the more ambiguous guidelines in effect today.  Note that the penalties for misclassifying someone who should be an employee as an independent contractor can be significant including back employment taxes, associated interest, and penalties.

"So how will anyone find out?"  It usually happens when someone unfamiliar with the laws and working as an independent contractor gets terminated and files for unemployment benefits, listing the company as the last employer.  But independent contractors are not eligible for unemployment benefits; they are supposed to be independent businesses.  This can then trigger an audit.  And in the current economy with many state governments running budget deficits and the widespread abuses in this area, state auditors are getting much more aggressive about going after small businesses, which are much more likely to be in violation.

So what should a small business or startup do to protect themselves?

1. Signed Independent Contractor Agreement - You should have a signed agreement drafted by an attorney.  It should spell out that the contractor is responsible for filing and withholding their own taxes and have their own insurance (general liability, workman's comp if applicable).  It should also have a statement of work that preferably outlines a work project with milestones, deliverables, and project fee vs. just calling out a rate and general duties.
2. Determine what control is necessary over the way the work is performed - While you have the right to determine what the work product standards and deliverables should be, the more the contractor determines how, where, and when the work gets done, the more likely the contractor will be considered independent.  If a job requires that the person follow your detailed policies and procedures, under your supervision, at your premises, using your equipment, you probably need to hire an employee.
3. Review the IRS guidelines mentioned above -  See how many of these factors your contractor can pass.  The more the better.
4. Check to see if the job falls into the "statutory" category - There are certain jobs that have been defined by law to be employees.  Examples can include officers of corporations, full-time dedicated sales people and insurance agents, agent/drivers in food service, laundry, or dry cleaning, or home workers performing work on employer supplied materials.  The list can differ from state to state. 

If in doubt, consult a human resources specialist or labor attorney for advice.  The hour fee is worth it.  Or if you don't want to do that, all you have to do is file a Form SS-8 with the IRS.  They'll be happy to provide their objective, unbiased opinion.