When hiring independent contractors, you'll want to make sure that government agencies view them as truly independent business people, not as employees by a different name. The penalties for misclassifying employees as independent contractors can be significant. You can avoid trouble by following these tips. (For more information on hiring independent contractors, including contracts you can use to set up the terms of the relationship, get Working With Independent Contractors, by Stephen Fishman (Nolo).
The single most effective thing you can do to avoid IRS and other government audits is to hire independent contractors (ICs) who have incorporated their own businesses, rather than those who operate as sole proprietors or partners in a partnership. When you hire incorporated ICs, you enter into a three-tiered relationship: You pay the worker's corporation, which pays the worker, who is an employee of the corporation. Legally, you have no direct relationship to the worker at all, only with the worker's corporation (which cannot be classified as your employee).
When you hire an incorporated IC, the corporation stands between you and the worker. Legally, the corporation is the worker's employer, not you. It is supposed to pay state and federal payroll taxes, provide any employment benefits, and purchase workers' compensation insurance, not you. If the corporation fails to pay taxes, IRS and state auditors will go to the corporation and its owners, not to you (unless the corporation is a sham -- for example, you've required your employees to incorporate themselves just so you can classify them as ICs).
Even if you are audited by a government agency, you'll have an easier time proving that an incorporated worker is an IC. Forming a corporation is expensive and time-consuming, and operating one can be burdensome as well. Auditors are usually quite impressed by the fact that a worker has gone to the time and trouble to form a corporation. This is something that only people who are running their own businesses do. And people who are running their own businesses can't be your employees. In fact, the IRS audit manual on worker classification states that an incorporated worker will usually be treated as an employee of the worker's corporation, not of the hiring firm (your company).
Instead of hiring workers directly, many companies lease or rent them from outside leasing companies. Workers like these are sometimes referred to as temps, contract employees, or contingent or casual workers.
Employee leasing gives you many of the benefits of hiring ICs directly. You use them only when needed, you don't have to pay and withhold federal and state payroll taxes, and you don't have to provide employee benefits or workers' compensation coverage. Although it may cost more to lease workers than to hire them directly (because the leasing company will take a cut), you will get screened, trained workers--and reduced exposure to government audits over classification.
The benefit of leasing workers is that the leased workers are the leasing firm's employees, not yours. However, you could run into problems if you control a leased worker's performance on the job to such an extent that you are also considered an employer -- the worker's "joint employer," along with the leasing company. If this happens, the worker will be considered your employee.
You can avoid being a joint employer by making sure that you don't exercise control over leased workers. For example, you shouldn't negotiate directly with leased workers over compensation, working conditions, or performance; the leasing company should pay the workers from its own account (and decide how much to pay them); the leasing company should have the right to hire and fire leased workers, not your company; and the leasing company should decide which workers are assigned to perform which tasks. To avoid problems, you should always deal with an established leasing company and make sure that it pays all applicable taxes and workers' compensation premiums for its employees.
Once you have hired an independent contractor, there are a number of work habits you should avoid if you want the IRS and other agencies to respect that classification: