When Are Your Workers Independent Contractors?

If you own a small business, making a new hire could seem almost patriotic—your contribution to nudging down a persistently high unemployment rate. Yet it may not make financial sense. As you know all too well, the cost of an employee goes well beyond salary. Any benefits you provide—health insurance, retirement plan contributions—have to be added in, and there are also employment taxes for Social Security and Medicare that add almost 8% to the cost. You might save money and hassles with a different approach, engaging independent contractors when you need more help. But staying on the right side of employment law can be tricky when you use non-payroll workers.

Because independent contractors don’t officially work for your company, they don’t draw a regular salary, and you can use them as little or as much as you need them. And whatever you pay them, whether on an hourly or a project basis, your obligation ends there—you’re not also on the hook for payroll taxes or fringe benefits. Given all of those pluses, you might even be tempted to switch some employees to independent contractor status. But there’s one large potential drawback. If you don’t follow government rules to the letter, the IRS may refuse to accept workers as independent contractors and “reclassify” them as employees. That could result in your business being liable for tens of thousands of dollars in back taxes, penalties, and interest.

What distinguishes independent contractors from regular employees? Traditionally, the IRS has used a list of 20 factors to determine how a worker should be classified, but it recently consolidated the main points of that list into three categories.

1. Behavioral control. Evidence showing that your business has the right to direct and control how the worker performs services for the company is a sign that the worker should be classified as an employee. If you set hours for a contractor to be in your office, provide a desk or tools, and require, for example, that work be done in a particular order, it’s probable the IRS would consider that worker an employee. The more detailed your instructions, the more likely someone should be classified as an employee. On the other hand, if you simply tell someone what needs to be done—but without specifying how to do it—it may be fine to consider that person an independent contractor. It’s really the difference between focusing on process (with an employee) and results (for an independent contractor).

2. Financial control. Do you determine the business aspects of a job? If you provide tools (so the worker won’t have to invest in them), reimburse expenses, and just generally limit the worker’s risk of losing money on the arrangement, that argues for employee status. But if the worker is responsible for most of those things, he may be considered a contractor.

3. Type of relationship. The legal and contractual relationship between your company and a worker can also help determine the worker’s status. But merely having a contract calling someone an independent contractor or not offering the worker benefits that your employees receive won’t automatically mean that person is really a contractor in the eyes of the IRS. Other factors, such as whether a job is open-ended, whether it’s similar to work done by employees, and whether it’s crucial to your business also factor in.

Beyond paying attention to these considerations, few of which are cut-and-dry, you may be able to avoid IRS trouble under Section 530 of the 1978 Revenue Act, which says an employer is exempt from employment tax liability if it meets these requirements:

  • The company hasn’t treated the worker as an employee for any period and doesn’t treat workers in similar positions as employees.
  • All federal returns the company files (including information returns) consistently treat the worker as an independent contractor.
  • The company has a “reasonable basis” for not treating the worker as an employee. For example, your claim may be based on past cases or rulings, an IRS audit, or the established practices of your industry. Relying on the expert opinion of a tax professional may also bolster your position for obtaining Section 530 relief.

With significant tax dollars at stake, designating your workers correctly is crucial, and mistakenly calling someone an independent contractor could end up costing you much more than you saved by not treating him as an employee. If you have questions about your situation, get help from a specialist in employment taxes.

This article was written by a professional financial journalist for G.W. Sherwold and is not intended as legal or investment advice.

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