One of the ways that some companies control their costs and stay flexible during turbulent economic times is to hire independent contractors.
Generally speaking, independent contractors don’t receive health insurance benefits, workers compensation coverage, 401(k) retirement contributions and most other benefits that employees typically receive. Businesses also don’t have to contribute the “employer’s portion" of Social Security and Medicare.
It is sometimes easier to terminate the services of independent contractors as they typically work until a project is completed or under the very specific terms of a contract. In “at-will" employment states like Texas, this is less of a factor, but in some other States employers have much less leeway in terminating employees.
Some individuals prefer to work as independent contractors because they feel less constrained or bound to a particular employer and they can also deduct more of their expenses for tax purposes.
The IRS is concerned about situations where employers classify individuals as independent contractors when they really should be classified as employees. In some situations state workforce agencies are even more aggressive than the IRS in going after business. This often occurs when an individual, who was classified and paid as independent contractor, files for unemployment benefits. The state agency will typically open an investigation into the businesses employment practices which can be costly and result in severe fines.
This is usually where the trouble begins. If the IRS or a state agency finds that your company has been treating workers as independent contractors when they should have been treated as employees, then they will go after not only the taxes and benefits that should have been contributed, but also penalties. In some situations the penalties may be more than the taxes.
Below are the common law factors considered by the IRS and some states:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer?
- Type of Relationship: Are there written contracts or employee type benefits? Will the relationship continue and is the work performed a key aspect of the business?
The issue is control. If the IRS or state employment agency finds that the employer is controlling the manner in which the worker is doing their job then they will likely find that the worker is an employee and not an independent contractor.
One of the things that the IRS looks at is the existence of a written contract. The independent contractor’s contract must have some very specific language and it must be understood and agreed upon by all the parties.