Chapter 1
Benefits and Risks of Working With Independent Contractors

Benefits of Using Independent Contractors.................................................... 4

Financial Savings................................................................................................... 4

Reduced Exposure to Lawsuits....................................................................... 6

Flexibility in Hiring............................................................................................... 7

Risks of Using Independent Contractors.......................................................... 8

Federal Audits......................................................................................................... 8

State Audits.............................................................................................................. 8

Loss of Control........................................................................................................ 9

Loss of Continuity................................................................................................. 9

Restrictions on Right to Fire.......................................................................... 10

Liability for Injuries........................................................................................... 10

Possible Loss of Copyright Ownership...................................................... 10

There are many benefits to hiring ICs, but there are serious risks as well. No book can tell you whether you should use ICs in your business, but this chapter will help you make an informed decision by summarizing the potential advantages and disadvantages.

Benefits of Using Independent Contractors

It can cost less to use ICs instead of employees because you don’t have to pay employment taxes and various other employee expenses for ICs. In addition, you will be less vulnerable to some kinds of lawsuits. Perhaps most importantly, hiring ICs gives you greater flexibility to expand and contract your workforce as needed.

Financial Savings

It usually costs more to hire employees than ICs because, in addition to employee salaries or other compensation, you will have to pay a number of employee expenses. These expenses add at least 20% to 30% to your payroll costs, often more. For example, if you pay an employee $10 per hour, you must pay an additional $2 to $3 or more per hour in employee expenses.

You incur none of these expenses when you hire an IC. Even though ICs are often paid more per hour than employees doing the same work, you will still save money in the long run by using ICs.

In addition to the costs of payroll processing, the most common employee expenses include:

federal payroll taxes

unemployment compensation insurance

workers’ compensation insurance

office space and equipment, and

employee benefits such as paid vacation and health insurance.

Federal Payroll Taxes

Employers must withhold and pay federal payroll taxes for employees. They must pay a 7.65% Social Security tax and a small—usually 0.8%—federal unemployment tax out of their own pockets. In addition, employers must withhold Social Security taxes and federal income taxes from their employees’ paychecks, and periodically hand this money over to the IRS. (See Chapter 3.)

In contrast, you don’t have to withhold or pay any federal payroll taxes for ICs. This will help you save money, not only in taxes, but in book­keeping costs as well.

Unemployment Compensation

Employers in every state are required to contribute to a state unemployment insurance fund on behalf of most employees. The unemployment tax rate is usually somewhere between 2% and 5% of employee wages, up to a maximum amount set by state law. (See Chapter 5 for more on unemploy­ment compensation rules.)

Workers’ Compensation Insurance

Employers must provide workers’ compensation insurance coverage for most types of employees, to provide some wage replacement and reim­bursement of medical bills if an employee is injured on the job. Employers can get workers’ compensation insurance either from private insurers or state workers’ compensation funds. Premiums can range from a few hundred dollars per year to thousands, depending upon the employee’s occupation and a company’s claims history. Employers don’t have to carry workers’ compensation insurance for ICs. (See Chapter 6 for information about state workers’ compensation laws.)

Office Space and Equipment

Employers typically provide their employees with workspace and whatever equipment they need to do their jobs. This is not necessary for ICs, who ordinarily provide their own workplaces and equipment. Office space is usually an employer’s second biggest expense; only employee salaries and benefits cost more.

Employee Benefits

Although not required by law, employers usually provide their employees with benefits such as health insurance, paid vacations, sick leave, retirement benefits, and life or disability insurance. You need not—and should not—provide ICs with such benefits.

Health insurance costs, in particular, can be enormous. Many employers are cutting back on health insurance benefits for employees in attempts to save money. But these kinds of cutbacks can have high costs in employee discontent.

Reduced Exposure to Lawsuits

When you hire employees, you may be subject to some types of legal claims that ICs can’t make against you.

Labor and Antidiscrimination Laws

Employees have a wide array of rights under state and federal labor and antidiscrimination laws. Among other things, these laws:

impose a minimum wage and require many employees to be paid time-and-a-half for overtime

make it illegal for employers to discriminate against employees on the basis of race, religion, gender, national origin, age, and disability

protect employees who wish to unionize, and

make it unlawful for employers to knowingly hire illegal aliens.

In recent years, a growing number of employees have brought lawsuits against employers alleging violations of these laws. Some employers have had to pay hefty damages to their employees. In addition, various watchdog agencies, such as the U.S. Department of Labor and the U.S. Equal Employment Opportunity Commission, have authority to take administrative or court action against employers who violate these laws.

Few of these antidiscrimination and employment laws apply to ICs, so you have much less exposure to these kinds of employee claims and lawsuits when you use ICs instead of employees. (See Chapter 8.)

Wrongful Termination Liability

Employees can also sue for wrongful termination. In these legal actions, an employee claims that his or her firing was illegal or constitutes a breach of contract. Wrongful termination laws vary from state to state. Under some circumstances, for example, it might be a breach of contract for you to fire an employee without good cause. To guard against wrongful termination claims, employers must carefully document the reasons for firing an employee, so they can defend their actions in court, if necessary.

ICs cannot bring wrongful termination lawsuits. However, there usually are contractual restrictions on when you can fire an IC. For example, your contract might state that you can fire an IC only with written notice, or only for failing to meet his or her obligations under the contract. If you disregard these limits, you could face a breach of contract lawsuit.

Liability for Workers’ Actions

When you hire an employee, you’re liable for anything he or she does within the scope of employment. For example, if an employee gets into an auto accident while making a delivery for work, you may be liable for the damages.

Subject to several important exceptions, this is not the case with ICs. You are not liable for an IC’s actions, work-related or not, unless:

the IC you hired was not qualified to do the job and you were negligent in hiring him or her

an injury occurs because of your improper instructions to the IC

you know the IC is violating the law in working for you—for example, you hire an unlicensed IC to perform work that requires a construction contractor license, or

you hire an IC to do work that is inherently dangerous—for example, building demolition.

Flexibility in Hiring

Working with ICs provides a level of flexibility that you just can’t get from employees. You can hire an IC to accomplish a specific task, which gives you specialized expertise for a short period. You need not go through the trauma and potential severance costs (and lawsuits) of having to lay off or fire an employee. And an experienced IC can usually be productive immediately, eliminating the time and expense of training. By using ICs, you can expand and contract your workforce as needed, quickly and inexpensively.

Risks of Using Independent Contractors

After reading about the possible benefits of using ICs, you might be thinking: “I’ll never hire an employee again; I’ll just use independent contractors.” But be aware that there are some substantial risks involved in classifying workers as ICs.

Federal Audits

The IRS wants to see as many workers as possible classified as employees, not ICs, so that it can immediately collect taxes based on payroll with­holding. Also, the IRS believes that ICs are more likely to underreport their income when tax time rolls around. In recent years, the IRS has mounted an aggressive attack on employers who, in its view, misclassify employees as ICs.

If the IRS audits your business and determines that you have mis­classified employees as ICs, it may impose substantial interest and penalties. Such assessments can easily put a small company out of business. The owners of an unincorporated business may be held personally liable for such assessments and penalties. Even if your business is a corporation, you could still be held personally liable for the tax, interest, and penalties.

Other agencies can also audit businesses for misclassifying employees. These include the Department of Labor, which enforces the federal minimum wage and hours laws; the National Labor Relations Board, which enforces employees’ federal right to unionize; and the Occupational Safety and Health Administration, which enforces workplace safety laws. (See Chapter 8 for information about labor and antidiscrimination laws.)

State Audits

Audits by state agencies are even more common than federal audits. State audits most frequently occur when workers who were classified as ICs apply for unemployment compensation after their services are terminated. Your state unemployment compensation agency will begin an investigation, and you may be subject to fines and penalties if it determines that your workers should have been classified as employees for unemployment compensation purposes.

If workers classified as ICs are injured on the job and apply for workers’ compensation benefits, you can expect an audit by your state workers’ compensation agency. Very substantial fines and penalties can be imposed on businesses that misclassify employees as ICs for workers’ compensation purposes. You may even face a court order preventing you from doing business until you obtain workers’ compensation insurance. (See Chapter 6 for more about state workers’ compensation laws.)

Although not as common as unemployment insurance or workers’ compensation audits, your state tax agency may also audit to ensure that your workers are properly classified for purposes of your state income tax law. Again, fines and penalties may be imposed for misclassifying employees as ICs. (See Chapter 5 for more information about state tax laws.)

Loss of Control

Another possible drawback to classifying workers as ICs is that you lose control over the worker. Unlike employees, whom you can closely supervise and micromanage, you have to leave independent contractors alone to do the job you are paying them to do. If you help them too much or interfere too much in their performance, you risk turning them into employees. (See Chapter 2 for more about this control issue.)

Some business owners want to be in charge of everything and everybody involved with their business. If you’re one of them, and you want to control how your workers do their jobs, classify them as employees.

Loss of Continuity

Generally, employers use a particular IC only as needed for short-term projects. This can result in workers constantly coming and going, which can be inconvenient and disruptive for any workplace. And the quality of work you get from various ICs may be uneven. One reason businesses hire employees is to be able to depend on having the same workers available day after day.

Restrictions on Right to Fire

You do not have an unrestricted right to fire an IC as you do with most employees. Your right to terminate an IC’s services is limited by the terms of your agreement. If you terminate an IC who performs adequately and otherwise satisfies the terms of the agreement, you’ll be liable to the IC for breaking the agreement. In other words, the IC can sue you and get an order requiring you to pay a substantial amount of money in damages.

Liability for Injuries

Employees covered by workers’ compensation who are injured on the job cannot sue you for damages. Instead, they can file workers’ compensation claims and receive workers’ compensation benefits. This is not the case with ICs. They can sue you for damages if they claim they were injured because of your negligence, such as your failure to provide a safe work­place. If the injuries are substantial and your negligence is clear, you may end up having to pay quite a bit of money in damages. When you hire ICs, you should have liability insurance to cover the costs of such lawsuits. Depending on your situation, this may or may not be cheaper than obtaining workers’ compensation insurance.

Possible Loss of Copyright Ownership

If you hire ICs to create works that can be copyrighted—for example, book chapters or photographs—you will not own the legal rights to the work unless you use written agreements transferring copyright ownership to you in advance. This is not the case with employees. (See Chapter 9 for information about intellectual property issues.)