Employing Independent Contractors

Beware the risks of managing independent contractors as you would employees

by Kimberly Perkins, Green Apple Resources, LLC, NH

Your business is starting to grow. You have no employees, or perhaps a few, but you can no longer handle the workload yourself. You find yourself stuck in a difficult situation and there is insufficient budget to add employees to your team. One immediate option in addressing the work crunch can involve hiring independent contractors. Before taking this step, it is important to understand the tax rules and implications related to this option.

The costs of hiring regular employees can be considerable, including Worker’s Compensation insurance, Social Security, and Medicare taxes to pay. Additional costs that may be required to attract good help might include health insurance, vacation time, and other benefits. There is also the added overhead to manage payroll, tax withholding, tax deposits, and quarterly tax filings, which is often outsourced to a payroll company or bookkeeper, but still time consuming.

When faced with these hurdles small business owners often decide to hire independent contractors. But you must acknowledge the difference between an employee and a contractor, as workers’ rights are protected and enforced by Federal laws.

Employee or Independent Contractor?

Regardless of whether you consider a person who works for you to be an employee or an independent contractor it really does not matter. What’s more important is how the Federal Government perceives that person’s status. And that perception determines your tax-filing liability vis-à-vis withholding, social security and Medicare, and unemployment taxes. Knowing a worker’s status up front will save you headaches down the road.
In general, someone who performs services for you is your employee if you control 1) what work is to be done and 2) how such work will be done.
If you wish to hire independent contractors as opposed to employees, the following tips help to ensure that the IRS agrees with you on the status of these workers.

  • Be careful, when advertising for independent contractors. Do not place newspaper ads in the “Help Wanted” sections and try to avoid using phrases such as salary, wages, or steady work.
  • When establishing the relationship, avoid setting a regular pattern of daily or weekly hours. A self-employed individual, such as an independent contractor, presumably has the opportunity to select when and where he or she will work.
  • Allow contractors to supply their own tools, supplies, and equipment wherever possible in the performance of the services required. This will demonstrate that the contractor shares a risk of loss as well as an opportunity for profit.
  • Retain on file any business cards, circulars, or even telephone directory ads.
  • Permit contractors to hire their own assistants if necessary.
  • If possible, compensate your independent contractors on a per-job basis rather than by the hour or week. Always ask for an invoice or statement before paying for any work that has been performed and, if possible, make checks payable to a company rather than to an individual.
  • Do not directly reimburse contractors for any expenses they might have, for gasoline, meals, etc. Such expenses should be billed as part of the contractor’s set fees.
  • Ask the contractor to provide you a certificate of insurance, showing at minimum, business liability/umbrella coverage.
  • Should you become dissatisfied with a contractor’s work, do not discharge that contractor as you might an employee. If any dispute cannot be resolved businessperson-to-businessperson, you can discontinue the relationship by offering no more work. (Note: if a contract exists, any disputes should be handled in accordance with the terms of the contract.)

Try to always execute a contract between your company and an independent contractor. This can be a formal contract (many can be found on the web or in business books), or a more informal letter of agreement. Either way, both parties should sign the agreement, and keep an original signed copy in your files. This can be used on your behalf to illustrate the validity of an independent contractor relationship, should the IRS come knocking.

Serious Penalties

If you do not hold firm on how you manage your contractors and their employment status, you can open the door to difficulties later on. The IRS, as an agency, holds little sympathy and empathy for business owners who hire workers that should correctly be considered employees but are paid as independent contractors. And it has a whole arsenal of civil and criminal penalties it can impose upon employers, whether the misclassification is merely a misunderstanding of the law (negligent) or willful. Some, but not all, of these penalties are listed below.

  • Negligent Failures

Failure to withhold income taxes. The employer is subject to the penalty of 1.5 percent of wages paid, plus interest compounded daily.
Failure to withhold FICA (Social Security) taxes. The employer is subject to the penalty of 20 percent of the FICA tax on the employee, plus interest compounded daily.
Failure to report workers’ wages or other payments on Forms W-2 or 1099-MISC. The employer is subject to the penalty of 3 percent of wages paid and 40 percent of the FICA tax.

  • Willful Failures

Failure to file tax return relating to employment taxes. The employer is subject to the penalty of paying the employer share of Social Security and unemployment taxes, as well as a penalty equal to 5 percent of the tax for each month of the failure to pay, up to a maximum of 25 percent of the tax.
Failure to pay employment taxes. The employer is subject to the penalty of 0.5 percent of the tax, for each month of the failure to pay, up to a maximum of 25 percent of the tax.

  • Understatement of Employment Taxes

The employer who, either negligently or willfully, understates its liability for Social Security and unemployment taxes is subject to the penalty of 20 percent of the understatement.

  • Fraudulent Understatement of Employment Taxes

The employer who fraudulently understates its liability for Social Security and unemployment taxes is subject to the penalty of 75 percent of the understatement.

  • Criminal Penalties

Willful failure to collect and remit withholding taxes and the employee portion of FICA taxes. Each such failure is a felony that, on conviction, results in a fine up to $10,000 or imprisonment up to five years, or both.
In addition to these Federal penalties, State and Local authorities may impose penalties of their own.
Thus, while it might be cost effective to hire workers as independent contractors, be sure to treat them as such, or it could end up costing you even more than having hired them as regular employees in the first place.