Many corporations, large and small, use independent contractors rather than employees for some jobs. They can provide flexibility, cut costs and reduce paperwork. However, if you’re not careful how you use independent contractors, you may have a tax problem with the IRS or State unemployment authorities and other potential problems with the Department of Labor, Wage and Hour Division or State Workers Compensation officials.
Independent contractors may not have to be included in fringe benefit coverage, including vacations, holidays, sick days, 401(k) plans, funeral leave or retirement plans. But the big advantage in using them is in the area of payroll taxes. For employees, you must withhold part of each paycheck, match the withheld portion and send both sides to the IRS. There’s also the accounting time and costs involved.
For independent contractors, compensation is simpler: You send checks to the workers. At the end of each year, you send information reports (Form 1099) to the contract workers and to the IRS.
The IRS, however, prefers that you classify workers as employees rather than independent contractors because it likes to have payroll taxes come in automatically and on time. Therefore, if there’s any doubt at all, the IRS will likely re-classify independent contractors as employees.
Misclassification of an employee as independent contractor can be costly.
If your corporation has been paying workers as independent contractors, but the IRS or State unemployment compensation officials claim that they’re really employees, you’ll owe back taxes, interest and penalties and also face possible tax liens.
How can you tell the difference between an employee and an independent contractor?
First, use a written Independent Contractors Agreement and be sure your independent contractor and your corporation sign the agreement. Next, the most important factor is control. If you have the right to control how and when a person works, that person is most likely an employee.
Another important factor is a worker’s risk of loss. A person who pays none of his or her own business expenses and is guaranteed regular compensation is likely to be considered an employee, but one who pays some expenses, with uncertain earnings prospects, may be an independent contractor.
Independent contractor agreements let companies fill necessary yet temporary positions without having to hire a full or part-time employee while avoiding the need to provide training or supplies. Independent contractors typically have more urgency and reason (as entrepreneurs) to provide a higher quality of service to warrant earning continued business. A well-written agreement will protect both companies and independent contractors from liabilities and lawsuits by clearly specifying respective roles, duties, payments, deadlines, and dispute resolution, among other procedures relative to the project and working relationship.