Working With Independent Contractors
Working With Independent Contractors
Avoid IRS issues!
Stephen Fishman, J.D.
July 2014, 8th Edition
Hire independent contractors without worry
Working with independent contractors saves you money and gives you flexibility in hiring. But there are risks in trying to establish independent contractor relationships. This book shows you how to avoid mistakes that can lead to lawsuits or costly fines from the IRS and other agencies.
If you hire programmers, writers, designers, marketing consultants, nurses, janitors, telemarketers, drivers -- in a word, anyone -- on a contractual basis, you need Working With Independent Contractors. This book shows you how to:
- determine who qualifies as an independent contractor
- assess the risks of hiring freelancers
- safeguard your company's intellectual property
- protect yourself if there's a legal dispute
- handle - and settle - an IRS audit
The 8th edition -- completely revised to reflect the latest laws and court rulings -- includes detailed examples of how a business should hire independent contractors.
“Explains the proper relationship between a company and a contractor.”
-San Francisco Chronicle
“Comprehensive, current and savvy, this is highly recommended...”
“A guide to the mistakes and benefits and, most importantly, tax implications of hiring people on a contractual basis.”
-Orange County Register
- Independent Contractor Agreement
- Independent Contractor Questionnaire
- Worker Classification Checklist
- Documentation Checklist
- plus additional clauses to use to customize these forms
Your Legal Companion for Working With Independent Contractors
1. Benefits and Risks of Working With Independent Contractors
- Benefits of Using Independent Contractors
- Risks of Using Independent Contractors
2. The Common Law Test
- When a Legal Test Is Necessary
- The Right of Control Is Key
- Factors for Measuring Control
- Evaluating a Worker's Status
3. How the IRS Classifies Workers
- Four Steps to Classification Under the IRS Rules
- Step One: Check Statutory Independent Contractor Rules
- Step Two: Analyze the Worker Under the Common Law Test
- Step Three: Check Statutory Employee Rules
- Step Four: Check the Safe Harbor Rules
4. IRS Audits
- Why Audits Occur
- Audit Basics
- The Classification Settlement Program
- Voluntary Classification Settlement Program
- IRS Assessments for Worker Misclassification
- Penalties for Worker Misclassification
- Interest Assessments
- Criminal Sanctions
- Obamacare Penalties
- Retirement Plan Audits
- Worker Lawsuits for Pensions and Other Benefits
5. State Payroll Taxes
- State Unemployment Compensation
- State UC Classification Tests
- State Disability Insurance
- State Income Taxes
6. Workers’ Compensation
- Basics of the Workers’ Compensation System
- Who Must Be Covered
- Exclusions From Coverage
- Classifying Workers for Workers’ Compensation Purposes
- If Your Workers Are ICs
- Obtaining Coverage
7. Hiring Household Workers and Family Members
- Household Workers
- Family Members as Workers
8. Health, Safety, Labor, and Antidiscrimination Laws
- Obamacare (Affordable Care Act)
- Federal Wage and Hour Laws
- Federal Labor Relations Laws
- Family and Medical Leave Act
- Fair Credit Reporting Act
- Antidiscrimination Laws
- Worker Safety Laws
- Immigration Laws
9. Intellectual Property Ownership
- What Is Intellectual Property?
- Laws Protecting Intellectual Property
- Copyright Ownership
- Trade Secret and Patent Ownership
10. Strategies for Avoiding Trouble
- Hiring Incorporated Independent Contractors
- Employee Leasing
11. Procedures for Working With Independent Contractors
- Before Hiring an IC
- While the IC Works for You
- After the IC’s Services End
12. Independent Contractor Agreements
- Using Written Agreements
- Drafting Agreements
- Essential Provisions
- Optional Provisions
- Sample IC Agreement
13. Help Beyond This Book
- Finding and Using a Lawyer
- Help From Other Experts
- Doing Your Own Legal Research
- How to Use the Interactive Forms
- Editing RTFs
- List of Forms
Appendix B: Contractor’s Screening Documents
- Independent Contractor Questionnaire
- Documentation Checklist
- Worker Classification Checklist
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................................................................................ 10
Worker Misclassification Lawsuits............................................. 11
Loss of Control........................................................................... 11
Loss of Continuity...................................................................... 11
Restrictions on Right to Fire....................................................... 12
Liability for Injuries..................................................................... 12
Possible Loss of Copyright Ownership...................................... 12
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.
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. On average, these expenses add 30% to your payroll costs. For example, if you pay an employee $10 per hour, you must pay an additional $3 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 the former.
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 like 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 and Medicare tax and a small—usually 0.8%—federal unemployment tax out of their own pockets. In addition, employers must withhold Social Security and Medicare 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.
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 in order to provide some wage replacement and
reimbursement of medical bills if an employee is injured on the job. Depending on the state, 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 the 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 isn’t 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.
Starting in 2015, the Affordable Care Act (also known as “Obamacare”) requires that all employers with the equivalent of more than 100 full-time employees (50 in 2016 and later) provide them with minimally adequate health insurance or pay a penalty to the IRS. The Obamacare employer mandate does not apply to independent contractors—they don’t count toward the applicable employee threshold. Thus, using ICs can save a hiring firm substantial sums on health insurance. (See Chapter 8 for detailed discussion of Obamacare.)
Employee Benefits Other Than Health Care Insurance
Employers usually provide their employees with benefits such as paid vacation, sick leave, retirement benefits, and life or disability insurance. You need not—and should not—provide ICs with such benefits.
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, or 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 constituted 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 his or her failing to meet 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 one of the following is true:
- 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.
- 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.
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.
The Department of Labor has taken particular interest in the worker misclassification issue. It recently hired hundreds of investigators and other enforcement staff to undertake a “Misclassification Initiative” designed to recover back wages and other benefits from employers who misclassified their workers as ICs.
(See Chapter 8 for information about labor and antidiscrimination laws.)
The following chart, prepared by the General Accounting Office, shows the principal government agencies that are concerned with misclassification of employees as ICs.
Legal Implications of Employment Classification
U.S. Department of Labor
Fair Labor Standards Act
Minimum wage, overtime, and child labor provisions
Family and Medical Leave Act
Job-protected and unpaid leave
Occupational Safety and Health Act
Safety and health protections
U.S. Department of Treasury—Internal Revenue Service
Federal tax law, including:
Federal income and employment rates
U.S. Department of Health and Human Services
Title XVIII of the Social Security Act (Medicare)
Medicare benefit payments
DOL/IRS/Pension Benefit Guaranty Corporation
Employee Retirement Income Security Act
Pension, health, and other employee benefit plans
Equal Employment Opportunity Commission
Title VII of the Civil Rights Act
Prohibitions of employment discrimination based on race, color, religion, gender, or national origin
Americans with Disabilities Act
Prohibitions of discrimination against individuals with disabilities
Age Discrimination in Employment Act
Prohibitions of employment discrimination against any individual 40 years of age or older
National Labor Relations Board
National Labor Relations Act
The right to organize and bargain collectively
Social Security Administration
Social Security Act
Retirement and disability payments
Legal Implications of Employment Classification (continued)
Unemployment Insurance law
Unemployment Insurance benefit payments
State tax law
State income and employment taxes
State workers’ compensation law
Workers’ compensation benefit payments
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.)
Moreover, several states, including Colorado, Delaware, Illinois, Indiana, Maryland, Minnesota, New Hampshire, New Jersey, Rhode Island, and Washington, have adopted laws that make it “fraud” for an employer to either “knowingly” misclassify its workers as ICs to avoid providing them with unemployment or workers’ compensation insurance, or fail to comply with federal or state prevailing wage and overtime pay rules.
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.)
Worker Misclassification Lawsuits
A growing number of worker misclassification lawsuits are being filed by workers under state and federal employment laws. Many of these take the form of class action suits in which plaintiffs’ lawyers represent tens, hundreds, or even thousands of similarly situated workers.
The plaintiffs in these cases seek payment for employee benefits such as minimum wages, overtime pay, sick leave, health care, and vacation pay. Such lawsuits have been filed in recent years on behalf of a wide variety of workers, including truckers, delivery workers, insurance agents, janitors, telecommunications support personnel, newspaper delivery carriers, health care professionals, “crowdsourced” workers, and even exotic dancers.
Loss of Control
Another possible drawback to classifying workers as ICs is that you lose control over them. 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 particular ICs 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 the same workers 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 him or her 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 who perform services at your place of business, 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.)
Ten Myths About Hiring Independent Contractors
Common misconceptions about classifying workers include the following:
1. If I issue IRS Form 1099-MISC, the worker is an IC.
2. Any worker I pay less than $600 in a year is an IC.
3. Part-time and temporary workers are always ICs.
4. A signed contractor agreement makes a worker an IC.
5. Everyone else is doing it, so it’s okay for me to treat my workers as ICs.
6. Workers who perform similar work for other businesses are always ICs.
7. A worker who has a business license and business card is an IC.
8. Workers paid by commission are always ICs.
9. Workers who perform offsite are always ICs.
10. You’re safe if you hire a worker as a subcontractor through a third party.
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