I get a lot of questions from my community about using independent contractors and/or freelancers instead of going through the hassle and expense of actually hiring employees. It’s tempting to categorize workers as independent contractors (ICs) rather than employees, because ICs are people considered to be in business for themselves. Therefore, your business is not required to pay state and federal payroll taxes or other employee benefits, which can add 20 to 30 percent to payroll costs. Instead, the IC is required to pay estimated taxes directly to the IRS four times per year. Sounds pretty good, doesn’t it?
Well, it won’t seem like such a good idea if the IRS determines that the worker you’ve classified as an IC is actually an employee. Yes, they can do that, and if they do — get out your checkbook. Not only will you have to pay the back taxes, but you’ll also be hit with a penalty of 12 to 35 percent of the total tax bill.
To avoid the heavy hand of the tax man, it’s important to understand the criteria used to judge the status of a worker. Different federal and state government agencies use a variety of tests to determine whether an actual independent contractor relationship exists. These agencies include: state taxing authorities, the U.S. Department of Labor, and state unemployment and workers’ compensation agencies. The most commonly recognized assessment is the IRS’s 20-factor test. Primarily, the classification hinges on the degree of control you exercise over the individual. Some of the IRS review criteria include:
- The individual’s ability to set his own hours and do the job in his own way.
- The individual’s ability to use her own methods as opposed to being required to undergo training from the purchaser of her services.
- The individual can earn a profit or suffer a loss from the activity.
- The individual is able to assign her own workers to do the job and is not required to do it personally.
- The individual is hired for one job and does not have a continuing relationship.
- The individual has more than one client at a time.
- The individual pays her own business and traveling expenses.
- The individual works off the employer’s premises and uses her own office, desk and equipment.
- The individual agrees to complete a specific job and is responsible for satisfactory completion, or she is obligated to make good for any failures.
Sometimes a written IC agreement can establish the nature of the relationship with the individual you are hiring. The agreement should clearly spell out the scope of the work the individual will perform, when it will be performed, and how much he or she will be paid. However, an agreement alone won’t be enough to avoid an IC being reclassified as an employee. So before you take the easy way out, make sure you carefully review what your relationship will be with the individual you are going to hire. A few dollars saved today could be a costly mistake tomorrow.
Note: The information in this article is provided for informational purposes only and should not be considered legal advice and not warranted or guaranteed. Keep in mind laws change over time and differ by jurisdictions so it is recommended you consult an attorney in your regarding business legal matters.