Preserving Your Status as an Independent Contractor

The IRS is always seeking to reclassify independent contractors as employees of the businesses it audits. (It gets more money from employees than from contractors, who can deduct business expenses from their income. And it gets its money faster from employees, who have to pay taxes every payday through payroll withholding.)

If you're reclassified as an employee, you'll suffer some consequences. For example, the hiring firm may decide not to use you any more because it doesn't want to pay the additional expenses of treating you as an employee. And reclassification as an employee could create additional tax burdens for you, if you have to forego some of the deductions to which you were entitled as an contractor.

So how do you make sure that the IRS and other government agencies (such as a state taxing authority or unemployment agency) classify you as an independent contractor? If you consistently follow the guidelines below, you'll have a good chance of surviving an audit with your contractor status intact.

Retain Control of Your Work

The most fundamental difference between employees and independent contractors is that employers have the right to tell their employees exactly what to do and how to do it. Don't permit a hiring firm to supervise or control you as if you were one of its employees. It's perfectly okay for the hiring firm to give you detailed guidelines or specifications for the results it expects from you. But how you go about achieving those results should be entirely up to you.

Following these guidelines will help you show that you are the one in charge:

• Don't ask for or receive training from the hiring firm.
• Don't let the hiring firm dictate your working hours, although the firm may give you a deadline for completing your work.
• Decide where you will do the work, unless the work has to be performed on the hiring firm's premises.
• Decide whether to hire assistants to help you; if you hire workers, pay and supervise them yourself.
• Don't ask for instructions from the hiring firm about how to do your job.

Show Opportunities for Profit and Loss

Because they run their own businesses, independent contractors have the opportunity to earn profits or suffer losses. If you run absolutely no risk of loss, you're probably not really an independent contractor. The best way to meet this test is to have recurring business expenses, such as office rent, equipment, and possibly salaries for assistants. This demonstrates that you could face a loss if you don't find enough work.

You can also show an opportunity for profit or loss by charging your clients a set price for a specific project, rather than billing by the hour or day. If the project price exceeds your expenses, you'll make money; if you charge too little, you'll come out in the red.

Look Like an Independent Business

Take steps to show you are an independent businessperson. Here are a few things you can do:

• Use a fictitious business name instead of your own name.
• Maintain a separate bank account for your business.
• Obtain all necessary licenses and permits for your profession.
• Carry business insurance.
• Don't accept employment benefits -- such as health insurance, paid vacations, or pension benefits -- from your clients; instead, charge your clients enough to purchase these items yourself.

Make Your Services Widely Available

Independent contractors usually offer their services to the general public, not just to one person or company. Government auditors will be impressed if you market your services to the public. Here are some ways to do this:

• Obtain a business card and letterhead.
• Set up a website advertising your services.
• Maintain listings in business and telephone directories.
• Attend trade shows and similar events.
• Join professional organizations.
• Advertise in newspapers, trade journals, and magazines.
• Mail or email brochures or other promotional materials to prospective clients.
• Phone potential clients to drum up business.

Have Multiple Clients

Government auditors will rarely question the status of an independent contractor who works for three or four clients at a time. If the nature of your work requires you to work full time for one client for a while, try to work for other clients over the course of a year. For example, you might work for one client for six months, then work for another client for the rest of the year.

Use Written Agreements

Use written independent contractor agreements for all but the briefest, smallest projects. Among other things, the agreement should make clear that you are providing your services as an independent contractor and that the hiring firm does not have the right to control the way you do your work. A written service agreement alone won't prove that you are an independent contractor, but it will show government auditors that you and your client intended for you to work as an independent contractor. For tips on creating service agreements, see Use Written Service Contracts for Your Clients.

Work Off Site

If possible, do your work somewhere other than the client's premises. This shows that you are not subject to the client's control.

Of course, there are some types of work that you will have to do at the hiring firm's premises. For example, if you are hired to lay carpet or paint an office, you will have to work at the client's workplace. The IRS won't count this against you, as long as the work you do requires it.

Don't Accept Employee Status

Some clients will hire you only as an employee, not as an independent contractor. This is a particularly common problem in the high technology industry. Because the government closely scrutinizes the hiring practices of high tech companies, and because of special IRS rules pertaining to high tech workers, high tech companies are often wary of using independent contractors.

You may be tempted to let one hiring firm classify you as an employee, particularly if other firms are willing to hire you as an independent contractor. But this is a bad idea -- it will attract the attention of the IRS, which could well decide to classify you as an employee for all of your jobs.

To learn more about preserving your independent contractor status, as well as other rules for independent contractors, get Working for Yourself: Law & Taxes for Independent Contractors, Freelancers & Consultants, by Stephen Fishman (Nolo).