For all of these reasons, using an independent contractor can be less expensive than hiring employees, which is particularly helpful for startups and small businesses.
Proceed with Caution to Avoid Complications
There are rules for who you can classify as a contractor, and who you can’t. And those rules are complex and not always black and white. And on top of that, they are not always applied consistently by the different governing agencies and judges who ultimately make the call on matters. So it’s really important that you get it right.
While there’s a long list of government agencies at both the federal and state levels who care how you classify workers, they can be broken down into three categories:
- TAX COLLECTION agencies, like the IRS and state-level Departments of Revenue — Obviously, they want to maximize tax revenues, and so they care whether you are properly withholding and submitting employee taxes, including Social Security and Medicare taxes.
- FEDERAL and STATE agencies that protect EMPLOYEE RIGHTS — At the federal level, there’s the Department of Labor, which oversees whether workers are being paid properly; OSHA, which cares whether workers are being kept safe; the EEOC, which protects workers against discrimination; and the National Labor Relations Board, which protects the rights of union workers. The Department of Labor at the state level also enforces laws affecting employee rights.
- State INSURANCE agencies, including the Department of Labor (which administers unemployment insurance) and the Workers’ Comp Board — They oversee whether employers are paying into the insurance funds in case employees are injured on the job or laid off. This is one of the biggest areas of risk for small businesses.
While they recognize that independent contractor relationships are fully legal, all of these agencies would prefer that you treat ALL workers as employees, and the burden of proof is on you to show that a worker is in fact an independent contractor.
And what happens if one of more of these agencies finds that your ‘independent contractors’ really should be classified as employees? Well, the penalties can be steep. You can be required to pay years in back taxes, at both the federal and state levels. You can also be required to pay back wages and retroactive insurance premiums, along with additional penalties. Then there’s the risk of lawsuits, including class action suits. All together, these penalties can cripple a business.
So how do these “misclassification” issues even come to light? It can happen if the IRS or the Department of Labor conducts an audit or a random investigation. The odds are probably in your favor on this front, but it does happen, even to small businesses.
The bigger risk may come from your workers. Workers don’t always understand that being an independent contractor means they can’t file for unemployment or make a workers’ comp claim if they get hurt on the job. If they go ahead and do that, and the agency finds out that you’re not treating them as employees when you should be, they can open up a much broader investigation into your business practices.
And then there’s a risk of a disgruntled worker calling you out. The IRS has a special form — Form SS-8 — that any worker can submit to request a review of their classification. And of course, there are the attorneys out there who advertise on billboards and on radio stations encouraging workers to file suit against employers for all kinds of misdeeds, including misclassifying them as contractors.
Speaking of odds… a national study found that 30% of businesses who responded weren’t doing it right. The thing is, in most cases, it’s not intentional — it’s just that employers don’t understand how to apply the complex rules.
Today, the use of independent contractors is way up, so that percentage is very likely higher. And because of that, all of those federal and state agencies are stepping up their audits and investigations, and they’re even sharing information at the federal and state level to help each other out. So if one agency finds you’re doing it wrong, they alert the other state and federal agencies.
Guidelines for Determining if Workers Are Independent Contractors
Using independent contractors is a smart and legitimate business practice, and it is well within your rights to use them to your advantage. You just need to be clear on the rules for classifying workers.
There are a number of different tests used by federal and state agencies, and the courts that enforce the regulations. They overlap quite a bit, but there are distinctions.
In all cases, it’s important to consider that no single factor within these tests is definitive. The totality of the circumstances is what matters, and that’s what makes it somewhat subjective.
Right to Control Test, or Common Law Test
The first test is known as the “Right to Control” test, or is sometimes called the “Common Law” test. This is the test used by the IRS and several other agencies. It looks at a number of factors across three different categories:
- How you BEHAVE toward the worker
- The FINANCIAL arrangement you have with the worker
- The nature of the RELATIONSHIP with the worker
In the BEHAVIOR category, the main question is whether you are acting like a “boss.”
Do you dictate how, when and where to do the work? That includes setting the work hours, assigning them a workspace or requiring them to work at your location, and providing tools and equipment, such as a computer.
Second, do you provide training to do the work? You may need to provide an orientation on your business, your products or your customers, but you shouldn’t be teaching them essential skills to do the job, like how to use a particular software or what daily procedures to follow.
And third, do you monitor performance? You can ask for progress reports to monitor how a project is coming along, but you shouldn’t be conducting performance reviews or taking disciplinary action as you would with an employee. Don’t write them up for being late or for not following internal procedures.
The more NOs you answer here, the better, when working with a contractor.
In the FINANCIAL category, these are the questions to ask yourself:
- Does the worker pay for his/her own business expenses? They may bill back for some of those expenses, but the worker pays them up front. And there may be ongoing fixed expenses, like a business license or advertising.
- Does the worker own or lease equipment or facilities? That includes things like a computer, a work vehicle with tools on it, and an office or shop.
- Does the worker have other customers or clients?
- Is the worker paid by the project (not ‘on the clock’ or a salary)?
- And finally, does the worker have potential for profit or loss? In other words, whether they make money in the end depends on what price they charge you in relation to the business expenses they incur.
In this list, you’re looking for lots of YESes in the case of a contract worker.
Finally, how is the RELATIONSHIP set up between you?
- Is there a written contract that says the worker is an independent contractor? This can go a long way to show intent on both your parts, but it’s not enough by itself.
- Is the worker eligible for benefits? If you’re providing paid time off or other benefits, that indicates an employee relationship.
- Is the relationship temporary or permanent? The more permanent, or even long-term, the relationship, the more it is going to be considered an employee relationship.
- Does the worker provide core business services? If you use a contractor to build a website for your construction company, that‘s not a core business service. But if you use a contractor to build websites for your clients as your primary service, that’s more likely to be considered an employee relationship.
Remember, you’re looking for the majority of factors to weigh in on the ‘independent contractor’ side, but not necessarily all of them. So that last one could be okay if all of the other factors indicate a contractor relationship and you’re using a freelancer to handle a peak in demand, for example. But you don’t want a situation where the contractor is taking the lead on dealing with a customer directly, for example.
Economic Reality Test
The second test that is commonly used is known as the “Economic Reality” test. That’s the test that’s preferred by the Department of Labor and OSHA. It’s broken down into six factors.
The first three factors are:
- “Right to Control”
- Does the worker control how the work is performed?
- Who pays for the equipment, materials and helpers if needed?
- “Length of Relationship”
- Is the relationship permanent or temporary?
These are essentially the same as what was covered earlier. The other three factors expand on some of the concepts with these questions:
- Does the work require special skills? The more routine the work is, the more likely it is to be considered an employee relationship. Think of an administrative assistant who helps around the office or a customer service rep who answers phones. They would be difficult to categorize as contractors. Contractors tend to have more advanced skills that require specialized training or experience — like a computer programmer or a marketing copywriter.
- “Level of risk”
- Does the worker’s ability to make money depend on his or her managerial skills? This is similar to the question of whether they control their profit and loss, but it looks at the level of decisions being made by the worker.
- To what extent are the worker’s services an integral part of the employer’s business? This one is similar to the ‘core services’ question in the IRS test, and also considers whether the worker is supervising company employees.
So, this test expects an independent contractor to have advanced skills, make independent decisions that affect his or her ability to make money, and do work that is not deeply integrated with the services being offered to customers.
There are a couple of other tests used by some courts and states. The Hybrid Test, for example, combines factors from the first two tests. Courts may look at the right to control along with the following factors:
- the kind of occupation, with reference to whether the work is generally done under the direction of a supervisor or is done without supervision
- the skill required for the particular position
- whether the “employer” or the individual in question furnishes the equipment used and the place of work
- the length of time the individual has worked for the “employer”
- the method of payment, whether by time or by the job
- the way the work relationship ends
- whether annual leave is provided
- whether the work is an essential part of the business of the “employer"
- whether the worker gets retirement benefits
- whether the “employer” pays Social Security taxes
- the intention of the parties
How to Protect Yourself with Independent Contractors
Follow these guidelines to make sure you don’t turn your contractor into an employee by accident …
- Let the worker decide he/she is an IC
- Set or track work hours
- Provide company business cards or email address
- Conduct performance reviews or take disciplinary action
- Provide paid time off or other benefits
- Provide helpers or support workers
- Pay hourly or salary (project-based pricing is best)
- Pay worker out of payroll system or account
- Withhold taxes or issue a W-2
- Contract former employees for similar duties
- Use an IC full-time for an extended period of time
And here are a few things you should do …
- Choose ICs with skills and expertise to work independently, without training and supervision
- Treat as a ‘vendor’ under accounts payable
- Be consistent with workers who perform similar duties