Is Saving Money By Hiring Independent Contractors A Good Idea?

Staff Report

Thursday, May 2nd, 2013

Businesses utilizing independent contractors rather than employees can save significant money when payday rolls around. It has been estimated that hiring an employee rather than a contractor costs an average of 25% more over the long term, and even more in dangerous trades with high insurance rates. Besides saving on the company’s share of social security, workers’ compensation,  and other payroll taxes, contractors are not eligible for whatever internal benefits the owners may provide to regular employees, such as health insurance, paid sick days, or retirement benefits. Plus, if an owner is unhappy with a contractor’s performance, they are easy to let go. They can usually be released at will due to contractual violations, or at least not rehired after the completion of a particular job. Given these obvious benefits, doesn’t it make sense for every business to use contractors exclusively?

Who Determines the Classification of a Worker?

Sometimes, an independent contractor is really an employee. It is not up to the employer to make that call. That is the job of the IRS, which has indentified approximately twenty factors used to determine a hiree’s classification. Those IRS identified factors cover a broad range of categories, but a few of the most significant are:

  • To what degree does the employer direct the actions of the worker?
  • Does the worker supply his or her own tools and equipment?
  • To what extent is there an ongoing relationship between the parties?
  • Is payment rendered regularly or only upon the completion of a job?
  • Does the worker perform the same or similar services for others or to the general public?
  • Who determines the timing and sequence of the work?
  • Must the services be rendered personally or can the worker hire others to perform the work?
  • Are those services an integral part of the original business’s operation?

As you can see, it is the intent of the IRS that a worker must exhibit an extremely high degree of independence from the employing business to be correctly categorized as an independent contractor. Other important considerations are whether or not the business has provided training to the worker, whether or not the worker is licensed, whether or not the worker has invested in his/her business, and whether or not he/she can profit or suffer a loss on the project. While the answers to some of these questions can be rather subjective, and while no single question determines conclusively the status of the worker, these are the questions an employer has to answer honestly to arrive at a proper classification.

What is the Penalty for Classifying Workers Incorrectly and How Do Businesses Get Audited?

If the government determines a business has been misclassifying a worker the repercussions can be severe. The business will be held liable for all payroll related taxes for the duration of that worker’s employment, plus interest. In some cases, owners, managers, and even bookkeepers can be held liable for recovery of uncollected payroll taxes. Even if the so-called contractors independently paid the taxes owed, the IRS often assumes the opposite, collects the full amount, and requires the offending business to prove otherwise. In addition, a 100% penalty is possible, along with a careful audit of all other workers’ statuses. Many businesses simply collapse under such scrutiny.

Because the IRS has determined that the self-employed are among those who most often misclassify employees either intentionally or in error, the Self-Employed Division is one of the larger areas within the IRS. They perform a high number of routine audits. State Worker’s Compensation Divisions and insurance companies are also active auditors, and many Oregon businesses, particularly those in industries known for utilizing both employees and contractors, are routinely examined annually. As a result, a close eye is kept upon the area of worker classification.

It is also quite common for businesses to experience problems after a workplace accident. Since contractors are not covered by worker’s compensation insurance and must buy insurance independently if they have it at all, they frequently challenge the validity of their worker status in attempt to pay for medical bills and to obtain injured worker unemployment benefits. Naturally, the relationship with the injured worker will be closely examined in response to such a claim. Again, a big claim by a misclassified injured worker can threaten the very survival of a small business, even before the IRS jumps into the fray.

How Can A Business Protect Itself When Legitimately Utilizing Contractors?

If you determine that your workers are indeed independent contractors or if you choose to hire a temporary worker as an independent, it would be wise to follow a few simple guidlines at the very least:

  • Make sure there is a written contract spelling out the nature of the relationship, and acknowledging that the contractor is free to offer similar services to others.
  • Pay upon completion of the job or at intervals that are task-related, and require an invoice to be submitted for every payment.
  • Encourage the worker to work at his or her own office rather than on site if possible.
  • Require proof that the contractor has insurance and a business license.
  • Do not provide tools or equipment.
  • Require proof that the contractor is reporting the pay on a tax return.

If you have an ongoing relationship with a contractor and wish for an absolute determination as to their status, the IRS has a form (SS-8) that requests that. 

Or better yet, check with a tax professional or an attorney specializing in Employment Law and Employee Relations for an opinion. Not only can these professionals advise you regarding your business, but they will also be aware of statutory exceptions that may affect your particular industry.

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