Do’s and Don’ts of Hiring an Independent Contractor

Photo courtesy Beneath_Bl1e_Skies

Independent Contractor Agreements – A Match Made in Heaven?

Today’s employers are watching their bottom line more closely than ever before, including examining the costs associated with maintaining a full time workforce.

At the same time, workers are looking for ways to increase their independence, decrease their commutes and overall to increase their quality of life.

Done right, independent contractor work can suit the needs of workers and businesses alike.

Independent contractor agreements of one kind or another are, indeed, a popular workplace trend. According to the U.S. Government Accountability office (GAO), there are about 42 million part-time, temporary, or otherwise non-traditional workers—often referred to as “contingent workers”—who together represent roughly 30 percent of the overall U.S. workforce.

This non-traditional labor pool often includes independent contractors, temporary workers, leased workers, agency workers, and others who do not have traditional employer/employee relationships. There are many bonuses to these arrangements for companies and workers alike.

Pluses and Minuses of Independent Contractor Arrangements

Businesses have the freedom to retain or not to retain contractors to suit their business needs, without concern for possible discrimination claims if things do not work out.

Likewise, the independent contractor isn’t constrained by any expectation or illusion of loyalty beyond the current contract, and is free to build a business that is not dependent on performing services for just one company. In today’s economy, it just may be best to scatter our workhour “eggs” among as many baskets as possible.

However, it is worth noting that there are drawbacks to independent contractor agreements for workers and companies alike, including lack of health care coverage for workers and possible tax and employment law liabilities for employers that incorrectly classify their workers as independent contractors.

Using an Independent Contractor Can Be Risky Business

Like any contractual relationship, there are do’s and don’ts to consider before engaging independent contractors, and the penalties for getting it wrong can be severe.

A person is not an independent contractor just because he or she and the business agree to treat the relationship as such. The law, not contract, determines whether a person is working as an employee or independent contractor, and treats the two very differently.

Differences include the requirement to withhold taxes and pay into the Social Security/Medicare system, obligation to pay overtime as otherwise appropriate, and coverage under employment discrimination, workers’ compensation, unemployment compensation, and labor relations laws.

The IRS and state tax agencies can and do fine employers for uncollected payroll taxes on employees misclassified as independent contractors, even if the misclassified employees have paid their taxes in full.

Lawsuits for overtime pay and benefits brought on behalf of workers improperly classified as independent contractors have resulted in large settlements and judgments.

Legislative Action On Independent Contractor Misclassification Is Underway

The Employee Misclassification Prevention Act of 2008 (H.R. 6111) is an attempt at the federal level to stop improper classification of workers as independent contractors — and may indirectly help plug the tax revenue drain associated with improper worker classification.

The bill, which amends the federal law that requires payment of overtime, the Fair Labor Standards Act, would add new record-keeping requirements, beef up Department of Labor (DOL) auditing for independent contractor misclassification, and encourage close cooperation between DOL and IRS in acting on information obtained from such audits. It provides severe consequences for those who get it wrong.

Therefore, should the bill pass, employers currently treating employees as independent contractors will need to prepare for more than just the possibility of a larger tax bill. The bill was referred to committee earlier this year, but may be on a fast track to passage after the November elections.

The take-away from all of this: the stakes are high. With that in mind, there are five basic guidelines to consider before employing independent contractors.

Look Before You Leap: Some Guidelines

What can an employer do to avoid chances of worker reclassification and the related legal and financial headaches when engaging independent contractors? Here are a few important guidelines to consider before engaging in this type of relationship:

  1. Create an agreement that defines a specific and closed-ended project. This agreement should be detailed enough to define the expected deliverables, dates, and total dollar amount associated with the project. When creating the agreement, be careful to focus on a specific project to be completed by the contractor rather than a general need (more indicative of an employee relationship). The agreement should focus more on the expected outcome of the project and less on the methods of achieving this outcome.
  2. Honor the terms of the agreement. As is often the case, a pretty agreement with terms that are not carried out in the actual conduct of the relationship isn’t worth the paper it’s printed on (not to mention the legal fee of a lawyer who drafted it).
  3. Use contractors who have already established their business. All else being equal, it is preferable to utilize a contractor who has solidified their status as an independent businessperson before engaging in an agreement.
  4. As a general rule, avoid immediately engaging former W2 employees of your business as independent contractors. Filing both a 1099 and a W2 tax form for the same social security number in the same tax year can be a red flag to auditing agencies. Best practice is to allow a break in service to let the contractor establish other clients and invest in their business.
  5. Be wary of being a contractor’s sole source of income. This can make it look more like an employee-employer relationship.
  6. Get clear on the meaning of “independent contractor”: the key word is “independent.” Ensure that the relationship reflects that a contractor is operating independently from your organization. IRS and state auditing agencies focus on three areas: behavioral control, financial control and the relationship of the parties. Review each of these factors and ensure that the independence is being maintained.
  7. Review this Web site from the IRS to be sure you are meeting IRS requirements for independent contractor classification. In addition, you’ll find a helpful discussion of this issue in Publication 15-A, The Employer’s Supplemental Tax Guide (available in PDF), which includes many examples.
  8. Conduct background checks and require appropriate confidentiality agreements. Although not all independent contractors who provide services to you need a lengthy background check, there is some comfort to be gained in conducting a check. Ask yourself: Should you let an outsider have access to internal databases and employee information? If your answer to this question is yes, then it might be a good idea to think through what that really means: A stranger is on site and has access to your employees and/or client information. Even if they’re off site, they may have access to your sensitive financial data or intellectual property. You should investigate prospective contractors’ background and require compliance with confidentiality measures, including signed confidentiality agreements, just as if they were employees.

What Factors Establish Independent Contractor Status?

We’ve examined what doesn’t constitute independent contractor status; now let’s look at what does.

An individual is more likely to be viewed as an independent contractor when they:

  1. May earn a profit, or suffer a loss, from the activity;
  2. Furnish the tools and materials needed to do the job;
  3. Are paid by the job or on commission, not by the hour;
  4. Make decisions about how they will do the work;
  5. Make the decision when and where to work;
  6. Have the ability to hire assistants and are responsible for paying them;
  7. Absorb their own business and travel expenses;
  8. Have multiple clients or are not dependent on one client as a single source of income;
  9. Do not receive employee benefits from the hiring company;
  10. Cannot be terminated for reasons other than non-performance without the client incurring a penalty for early termination of the project.

The costs of worker misclassification can be a financial hardship for many businesses. In the case of small companies, it can be financially devastating.

On the other hand, most companies perceive the reduction in operating costs and the flexibility that comes along with using an independent contractor as worth taking the risk. They could be making a big mistake.

Given the potential penalties, it’s best to take that ounce of prevention instead of paying for several pounds’ worth of cure. While independent contractor agreements can be great for both parties, it’s best to be sure before signing on the dotted line. Remember, just because workers are called “independent contractors” doesn’t make it so.

Thanks are due to Stephanie Ellis, Vice President of Compliance Services for WorkforceLogic, for providing inspiration and material for this article, and to Dawn Wolfe for her research and editorial assistance.

Leave a Reply