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).

Hire Incorporated Independent Contractors

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).

Consider Using an Employee Leasing 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.

Avoid Exercising Control Over Independent Contractors

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:

  • Don't supervise the IC or his or her assistants. The IC should perform services without your direction.
  • 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 provide ongoing instructions or training.
  • Don't provide the IC with equipment or materials unless absolutely necessary.
  • Don't give an IC business cards or stationery to use that have your company name on them.
  • Don't give an IC a title within your company.
  • Don't pay the IC's travel or other business expenses directly.
  • Don't give an IC employment benefits.
  • Don't require an IC to give you formal written 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 as you pay employees. Instead, require ICs to submit invoices, and pay them at the same time you pay other outside vendors.
  • 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.

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