A number of laws govern whether a worker is an independent contractor (IC) or an employee, and each of these laws has a different way of looking at the issue. For example, the IRS has one method of determining whether a person is an independent contractor, but your state workers' compensation board may use a different test.

Because of all these different laws (often referred to as "worker classification" rules), the issue of whether a worker is an IC is not one question, but many. Employers who don't take the time to learn the rules before they hire an independent contractor can get hopelessly confused -- and this confusion can lead to trouble with one agency or another. If you want to avoid problems such as fines and taxes, know the rules before you hire a worker.

The IRS

The IRS is probably the most important agency to satisfy when it comes to classifying a worker as an IC. Under the IRS's test, workers are considered employees if the company they work for has the right to direct and control the way they work -- including the details of when, where, and how the job is accomplished. In contrast, the IRS will consider workers independent contractors if the company they work for does not manage how they work, except to accept or reject their final results.

The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor. The agency is more likely to classify as an independent contractor a worker who:

• can earn a profit or suffer a loss from the activity
• furnishes the tools and materials needed to do the work
• is paid by the job
• works for more than one firm at a time
• invests in equipment and facilities
• pays his or her own business and traveling expenses
• hires and pays assistants, and
• sets his or her own working hours.

On the other hand, the IRS is more likely to classify as an employee a worker who:

• can be fired at any time by the hiring firm
• is paid by the hour
• receives instructions from the hiring firm
• receives training from the hiring firm
• works full time for the hiring firm
• receives employee benefits
• has the right to quit without incurring liability, and
• provides services that are an integral part of the hiring firm's day-to-day operations.

If you think the IRS would consider the worker an IC, you don't have to withhold federal payroll taxes for the worker, including Social Security taxes, federal disability taxes and federal income taxes. If the IRS would not consider the worker an IC, then you should withhold these taxes.

To find out more about the IRS test, go to the agency's website at www.irs.gov.

Your State Unemployment Compensation Board

If the worker meets your state unemployment compensation board's definition of independent contractor, you don't have to pay for unemployment insurance for the worker. If the worker does not meet this test, you should provide unemployment coverage for the worker, even if the worker qualifies as an IC under tests used by other agencies, such as the IRS.

To learn more about your state unemployment department's test, go to your state unemployment compensation board or your state department of labor. You can also try your local office of the Small Business Administration. For a list of SBA offices, check out the SBA's website at www.sba.gov.

If a worker whom you treates as an IC decides to apply for unemployment compensation -- which is reserved for employees -- it will be your word against the worker's. You say the worker was an IC, but the worker -- hungry for that unemployment check -- says otherwise. In such a situation, you'd better be prepared to back up your claim with documentation.

Your State Workers' Compensation Insurance Agency

If a worker meets your state workers' compensation agency definition of independent contractor, you don't have to pay for workers' compensation coverage for that worker. Otherwise, you should pay for workers' compensation coverage, even if the worker qualifies as an IC under other tests, such as the IRS test or your state unemployment board test.

To find out more about the workers' compensation test in your state, contact your state department of industrial relations or your state labor department. Your local office of the SBA might also have information on the subject. For a list of SBA offices, refer to the SBA's website at www.sba.gov.

If an IC is injured on the job and applies for workers' compensation -- something reserved for employees -- you might find yourself with an audit on your hands. You should be prepared from the beginning to prove that the worker was an IC under the workers' compensation board's test.

Your State Tax Department

If your state collects income tax, then you need to familiarize yourself with your state tax department's rules regarding ICs. If the worker will qualify as an IC under your state tax department's test, you do not need to withhold state income taxes from money that you pay the worker. Otherwise, you should withhold state taxes, even if the worker qualifies as an IC under other tests, such as the IRS test or the workers' compensation test. Contact your state tax board for details.

The U.S. Department of Labor

Finally, if the U.S Department of Labor would consider a worker an IC, you don't need to pay the worker overtime when the worker works more than 40 hours in a week. Otherwise, you should pay the worker overtime, even if the worker would qualify as an IC under other tests, such as the IRS test or your state tax department's test. For more information about the U.S. Department of Labor's test for ICs, refer to the agency's website at www.dol.gov.