Working With Independent Contractors: Avoiding Classification Problems

Make sure independent contractors aren't classified as employees by following these strategies.

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).)

Avoid Exercising Control Over Independent Contractors

Whether an individual is an employee or independent contractor (IC) is relevant to many different laws, including tax laws, wage and hour laws, unemployment compensation laws, and workers’ compensation laws. Federal and state agencies—such as the IRS or a state labor department—have their own tests for determining whether an individual has been misclassified as an independent contractor. However, common themes include: how much control the employer has over how, when, and where the work is performed; how much control the employer has over financial matters; and the relationship between the parties.

Your company can minimize misclassification claims by following these tips:

  • Don't supervise the IC or his or her assistants. The IC should perform services without your direction.
  • Don’t prohibit the IC from using subcontractors.
  • Don't let the IC work at your offices unless the nature of the services absolutely requires it.
  • Don't give the IC employee handbooks or company policy manuals.
  • Don't establish the IC's working hours.
  • Avoid giving ICs so much work or such short deadlines that they have to work full time for you.
  • Don’t prohibit ICs from working for other companies.
  • Don't provide ongoing instructions or training on how to do the work. (Giving specifications for the final product is generally fine.)
  • Don't provide the IC with equipment or materials unless absolutely necessary.
  • Don't give an IC business cards or stationery that have your company name on them.
  • Don’t give an IC a company email.
  • Don't give an IC a title within your company.
  • Don't pay the IC's travel or other business expenses, unless they are unique to the project and have been negotiated in advance.
  • Don't give an IC employment benefits.
  • Don't require an IC to give you regular status reports.
  • Don't invite an IC to employee meetings or functions.
  • Don't refer to an IC as an employee or to your company as the IC's employer.
  • Don't pay ICs on a weekly, biweekly, or monthly basis. Instead, require ICs to submit invoices, and pay them at the same time you pay other outside vendors.
  • Don’t provide ICs with W-2 forms.
  • Follow the terms of the IC agreement, including its termination provisions.
  • Don't give the IC new work after the original project is completed without signing a new IC agreement.

To learn more, see our article on how government agencies determine independent contractor status.

Hiring Incorporated Independent Contractors

One way that you can lessen the likelihood of independent contractor misclassification is to hire 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, 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. 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).

Just because an individual has incorporated does not automatically establish independent contractor status, though. Government agencies are more concerned with the actual working relationship than official paperwork. However, it can be evidence that the IC is actually running an independent business. Forming a corporation is expensive and time-consuming, and operating one can be burdensome as well. People are more likely to go through this trouble if they are legitimately running their own businesses.

Using an Employee Leasing Company

Instead of hiring workers directly, some 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. 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 possibly reduced exposure to government audits.

However, this arrangement is not without its risks. If your company has the right to control the worker’s performance or terms of employment, it could be considered to be a "joint employer" with the leasing company. If this happens, the worker will be considered an employee of both companies.

To minimize the risk of being found to be a joint employer, make sure that you don't exercise control—or have the right to exercise control—over leased workers. In general, your company should not:

  • have the power to hire or fire leased workers
  • control work schedules or conditions of employment of leased workers
  • determine the rate and method of pay for leased workers, or
  • maintain personnel records for leased workers.

If you’re considering using an employee leasing company, especially on a large-scale basis, consult with an employment lawyer to make sure your company is classifying workers properly.

Put the Proper Documentation in Place

It’s important to have documentation to support an independent contractor classification. Your company should have all ICs sign an Independent Contractor Agreement, setting forth the terms of the relationship. Learn more in our article on IC agreements.

You should also ask the contractor to provide you with proof that he or she is running an independent business. This might include corporate formation documents, the URL for the contractor's business website, a copy of the contractor's business license, and business cards and stationery. You can find more suggestions in our article on what documentation to get when hiring independent contractors.

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