How to Toe the Line When Hiring Independent Contractors and Reap Big Dividends

All you’re required to do is inform the IRS if you paid this worker more than $600 in one year.

The phrase Toe the Line is an Americanism first recorded in the early nineteenth century. The main meaning of this phrase is ‘to conform strictly to a rule, command, etc… For example, “Anyone who doesn’t toe the line can expect to meet the mayor in court, where, as it turns out, he has never lost a suit.” (U.S. News & World Report, 1996).

And…

An Independent Contractor is a person hired to work for others without having the legal status of an employee.

Hiring someone who qualifies as an Independent Contractor can provide an employer with some very BIG dividends…

Dividend #1: You don’t have to pay the employers share of the workers Social Security and Medicare taxes.

Dividend #2: You don’t have to withhold income taxes (federal or state) on his/her earnings.

Dividend #3: Not only do you reduce your bookkeeping and financial obligations, you’re not bound by many of the federal and state laws that normally govern the employer – employee relationship.

Dividend #4: You don’t have to provide office or other work space for the worker.

Dividend #5: You don’t have to provide fringe benefits (vacation, personal or sick time).

Dividend #6: You don’t have to provide health insurance or retirement benefits.

Dividend #7: If you become unhappy with the person’s work, you can fire him/her without going through the trauma often associated with firing an employee. Plus you don’t get stuck paying unemployment benefits.

All you’re required to do is inform the IRS if you paid this worker more than $600 in one year.

You’re responsible for filing a Form 1099-MISC at the end of the year if you paid the Independent Contractor $600 or more during the year. This form is sent to both the IRS and the contractor.

There are some basic qualification and guidelines you’ll have to follow when classifying someone as an Independent Contractor. As long as you make sure you meet these specifications, you won’t be challenged by the IRS.

A “No Sweat” Classification

It must be clear the contractor is in business for himself. The following characteristics guarantee you a “no sweat” Independent Contractor classification.

o The worker is available to perform services for many businesses.

o The worker has a fixed base of operation – a commercial or office location or a room at home and ongoing business expenses.

o He or she lists the business in the phone book or through newspaper ads, radio commercials, circulars, or other advertising media.

o He or she undertakes a job based on the results the client wants, but remains free to decide how to get the job done.

o The worker hires and pays for assistants, as needed.

o He/she has invested significant money in the business for equipment, vehicles and supplies.

o Depending on how his business goes, the worker may earn large profits, small profits or none at all — perhaps even suffers a loss.

o He/she incurs expenses in doing a job that won’t be reimbursed by the client.

Be very careful you don’t cross the line between Independent Contractor and Employee

If the work arrangement shares some characteristics of an employment relationship and some characteristics of the Independent Contractor, you are at risk with the IRS. To ensure you don’t invite an IRS audit there are two safe solutions to avoid crossing this somewhat ambiguous line.

Treat the worker as an employee. If you want to be safe and avoid any risk the IRS or any other government agency might determine you’ve mistakenly classified a worker as an Independent Contractor, follow the policy of always treating the worker as an employee.

Just remember, by doing this you and the worker will lose the advantages of the Independent Contractor relationship.

Require the worker to incorporate. The IRS will almost always treat this as a valid arrangement and accept the fact that the worker isn’t your employee but an employee of his or her own corporation. It’s legal in every state to form one-person corporations and the process can be simple and relatively inexpensive to do.

Here’s how it would work…

First, the worker forms a corporation under state law and obtains an Employer Identification number from the IRS.

Second, you sign a contract with the corporation. The corporation agrees to provide specified services for your business.

Third, the corporation hires the worker (who owns the corporate shares) as an employee to perform services required by your contract with the corporation.

Fourth, the corporation bills you as services are performed for your business under the contract.

Fifth, you pay the corporation…not the employee…for the services billed to your business.

Sixth, each time the corporation issues a paycheck to its employee, the corporation withholds federal income taxes, along with the employee’s share of Social Security and Medicare taxes. Periodically the corporation (using its own Employer Identification number) pays the IRS the withheld taxes along with the employer’s share of Social Security and Medicare taxes.

Accept a Measure of Risk.

If treating the worker as an employee or requiring the worker to incorporate aren’t practical, then you need to understand you’re opening yourself up to some legal risk. One way to reduce this risk is to get professional advice. See a tax expert, a lawyer or an accountant familiar with worker classification issues.

Another way you can reduce risk is to follow as many of the following suggestions as possible…

o Sign a contract with the Independent Contractor spelling out the responsibilities of each party and how payment is to be determined for each job. The contract should allow the Independent Contractor to hire his or her own assistants and to have as much say as possible in how the work will be performed.

o Require the Independent Contractor to furnish all or most of the tools, equipment and materials needed to complete the job.

o Avoid a commitment to reimburse the Independent Contractor for his/her business expenses. If necessary pay the Independent Contractor a little more, but have him/her assume the responsibility.

o If possible, arrange to pay a flat fee for the work rather than an hourly or weekly rate.

o Don’t provide employee-type benefits (paid vacation days, health insurance or retirement plans).

o Make it clear that the Independent Contractor is free to offer services to other businesses.

o Specifically state in your contract the contractor will carry his/her own insurance, including workers’ compensation coverage.

o Keep a file containing the Independent Contractor’s business card, stationary samples, ads, and his/her Employer Identification number to help show the contractor has an established business.

o You may need to disclose trade secrets of your business to an Independent Contractor. If so, include a clause in your contract prohibiting the Independent Contractor from disclosing or making any unauthorized use of these trade secrets.

Exceptions to Every Rule

As always, there are exceptions. Certain workers may fall into special categories and the usual IRS criteria won’t apply to them. For example, the federal tax law says the following workers are automatically treated as employees as far as Social Security taxes, Medicare taxes and federal unemployment taxes (FUTA) are concerned:

o Officers of corporations who provide service to the corporation

o Food and laundry delivery drivers

o Full-time sales people who sell goods for resale

o Full-time life insurance agents working mainly for one company

o At-home workers who are supplied with material and given specifications for work to be performed.

For these workers, you MUST withhold the worker’s share of Social Security and Medicare taxes and you MUST pay the employer’s portion of those taxes.

But… there’s always a “but”, isn’t there. (Smile)

You may or may not have to withhold income taxes for a legal employee — this depends on whether the worker qualifies as an employee or Independent Contractor under the usual IRS guidelines. For example…

Federal law provides that for tax purposes, licensed real estate agents and door-to-door sales people are generally treated as “non-employees” — in other words, they’re Independent Contractors. But… people in these positions may be treated as employees for the purpose of state payroll taxes and workers’ compensation coverage.

Or…

As a sole proprietor or partner in your own business, you’re neither an employee nor an Independent Contractor. You’re responsible for paying your own income tax and Social Security self-employment tax. But, if you’re a shareholder in a corporation and provide services to that corporation, you’re considered an employee.

The IRS analysis of who qualifies as an Independent Contractor is similar to the standards followed in most states for state taxes and unemployment rules… BUT…

In California, a person working for a licensed contractor who performs services requiring a license (i.e. erecting a building) is considered to be an employee unless the worker also has a valid contractor’s license.

So, Cover Your A–! If you plan to hire Independent Contractors, check with the employment office in your state to see if special rules apply.

Mistakes of Miscalculation

There are at least three ways the IRS can learn about your hiring and classification practices.

First, the IRS may look into the affairs of an Independent Contractor who hasn’t been paying his/her income taxes.

Second, disgruntled employees may complain to the IRS if they believe an Independent Contractor is getting favored treatment.

Third, during tax audits, the IRS routinely check to see if workers have been misclassified as Independent Contractors.

The presumption is always the worker’s an employee unless proven otherwise. If the status of a worker is questioned, it’s up to you to prove the worker’s an Independent Contractor rather than an employee.

If it’s proven that a worker was misclassified, it will cost you… BIG time. You’ll be responsible for paying the employee’s Social Security tax, federal income tax and federal unemployment insurance for up to three years… plus penalties and interest.

State government officials are also interested in businesses that misclassify employees as Independent Contractors. A state employment office may audit your business to see if there’s been any misclassification. The audit can be the result of a spot check by the state employment office or a request by an Independent Contractor for unemployment or worker’s compensation benefits. You may wind up owing money to a state unemployment insurance fund…

And…

If the IRS gets wind of the state’s action, you’ll probably face a federal audit too.

Again, it would be wise to get the advice of a tax expert before classifying someone as an Independent Contractor. Running your business as a corporation or an LLC may not protect you from personal liability for these penalties. If you’re an officer of the business or have authority to make payroll decisions, you may have to pay the penalties yourself…. OUCH!

So…

While there are definite benefits to hiring Independent Contractors, you must take measures to protect yourself and your business from simple miscalculations.

Just remember to always toe the line when dealing with the nebulous “buts” of the law.