Could Your Independent Contractors Get You in Trouble?

By Maria Valdez Haubrich

Since the recession began, small business owners have been turning more and more to independent contractors. There are many reasons why this is a good move: It saves money (you’re not paying a salary and benefits, but can pay per-project instead). It enables you to expand your workforce when you’re busy, without keeping people on the payroll during lean times. It eliminates the hassle of withholding income taxes, withholding Social Security and Medicare taxes, and paying unemployment tax on their salaries as you would with an employee. And it allows you to take advantage of the specialized skills of workers you might not be able to afford to hire full-time.

For all these reasons, even as the economy improves, independent contractors are likely to continue their reign as the preferred choice of small business owners. But there is one trap you need to be aware of when using this type of worker: If you’re misclassifying someone as an independent contractor and later, the IRS rules that the person should have been classified as an employee, you may end up being liable for employment taxes for the worker’s wages.

This is an easy mistake to make—even huge corporations have been caught in the web of confusion that surrounds this issue. Overall, however, whether a person is classified as an employee or an independent contractor is based on how much independence they have. Here are the three tests used by the IRS to assess independence:

1. Behavioral. Does your business dictate what the person does on a daily basis? Do you control the way the worker completes the job, such as requiring certain hours worked or the use of certain tools? Does the person have to come to your office or does he or she work from elsewhere?
2. Financial. Do you reimburse the person for expenses or does he or she pay them? Who provides the equipment used to do the job? Is the worker paid a salary or by piece or job? Can the person provide the same service to other similar companies without any restrictions from you?
3. Relationship. What type of contract do you have with this worker? Does the person get any benefits such as health insurance? Is the working relationship ongoing or does it end when a certain project is completed?

While some situations will be very clear-cut after you go through this list, there may be other cases where you still aren’t sure how a person should be classified. Visit the IRS website for resources and tools to help—you’ll find tests and even an online workshop on the topic. If that’s not enough, ask your accountant for help because making a mistake in this area can be costly.

Some cases are so complex that even an accountant can’t figure it out. If this applies to you, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. After receiving the document, the IRS will make an official decision as to the worker’s status. This can take several months, so in the meantime, check with your accountant to make sure you’re keeping proper records whatever the final decision turns out to be.

Image Courtesy: Karen Axelton

This entry was posted on Thursday, March 3rd, 2011 at 6:00 am and is filed under Accounting and Taxes, Compliance. You can follow any responses to this entry through the RSS 2.0 feed.


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