Are you looking to hire independent contractors for your business?
Hiring and maintaining motivated and talented independent contractors are critical to the success of your business.
You may want to hire an independent contractor rather than an employee for many reasons.
From the employer’s standpoint, considerable money can be saved by classifying a worker as an independent contractor.
A firm that hires a worker as an independent contractor does not have to provider workers’ compensation insurance, unemployment compensation, overtime, or job benefits, such as health insurance and a retirement savings plan. It also does not need to pay state and federal payroll taxes for the worker.
More importantly, when an independent contractor is hired, the employer is not required to pay any portion of the contractor’s Social Security and Medicare taxes.
Businesses usually use independent contractors for specialized, short-term work and it’s a great way to try out a worker before committing to a longer term.
Let’s get started…
Who is an Independent Contractor, Freelancer or Consultant?
An independent contractor is a person who is in an independent trade, business, or profession in which he or she offers services to the general public. An independent contractor is a person who works on a project as a freelancer rather than as an employee.
We’ll further discuss what this means.
There are various industries in which an independent contractor may work. Among the most common jobs are those that are based on creativity, such as freelance graphic designers, freelance content writers, photographers, website designers, freelance artists, business and financial advisors, general consultants, electricians, and carpenters, among others.
Independent contractors agree on the desired work product and control the means and manner of achieving the outcome. Independent contractors offer services to the public at large, not just to one business.
Workers who have significant entrepreneurial opportunity and retain direction and control over their work are more likely to be considered independent contractors.
A graphic designer who provides unsupervised, specialized work that is needed only irregularly, is a clear-cut example of an independent contractor.
Whether the workers are independent contractors or employees depends on the settings and factors of the work itself and the relationship between the employer and employee. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
It’s important to note that the earning of a person who is working as an independent contractor is subject to Self-Employment Tax. We will talk more in depth about this later in our lecture.
If you need additional personnel for your business but decide your business can’t afford to hire any more full-time employees, you might consider using the services of an independent contractor. With an independent contractor, you can save money because you don’t have to withhold and pay the person’s income, Social Security and Medicare taxes.
And while independent contractors do translate to lower payroll costs, be advised that the IRS scrutinizes this whole area of employee versus independent contractors very carefully. The IRS wants to make sure that your workers are properly classified and that the necessary income and payroll taxes are paid when due.
Benefits of Independent Contractors
Independent Contractors have many benefits, including:
First, since they are rarely tied to an employer, Independent Contractors are free to set their own rules of business.
This means that they control the means of their business. There’s no one that can tell them exactly how to do their work.
Second, since they usually develop a large network of clients, the loss of one or two clients often has a negligible effect.
Independent Contractors can work with anyone and pretty much everyone.
Third, many people simply like the idea of “being their own boss.”
Independent contractors simply enjoy not having to answer to a supervisor.
Lastly, as an artist or author of any tangible artwork, such as paintings, sculptures, photographs, or written works, a person is entitled to exclusive copyright ownership if they created the work as an independent contractor.
If the person created such works while in the employment of another person, the rights belong to the employer under most standard employment contracts.
Risks of Independent Contractors
When you look at the advantages of using independent contractors and the vague issue of which workers are considered employees, it is no surprise that some businesses push the envelope.
The Department of Labor and the IRS target businesses that use independent contractors. Thus it’s very important to correctly determine whether the workers you hire are independent contractors.
There are some associated risks of working with independent contractors. Employer misclassification of employees as “independent contractors,” either inadvertently or to avoid taxation and regulation, is widespread.
The most noteworthy risk is with the IRS. It’s reported that if an independent contractor reports more than $10,000 of earnings, or majority of income, from a single source, the IRS is likely to question the independence of the worker, and investigate the company.
An independent contractor can itself be a business with employees; however, in most cases, independent contractors operate as a sole proprietorship or single-member LLC. This means the independent contractor, as a business owner, incurs its own expenses to provide the contracted service, must acquire its own equipment to perform the service, and is responsible for business filings such as income tax returns.
Also, independent contractors are responsible for their own self-employment tax. Self-employment taxes are not withheld from the earnings of independent contractors who are required to voluntarily declare and pay estimated earnings taxes to the IRS, which can lead to a trap for contractors who run into financial difficulty and become tempted to put off making the required estimated tax payments.
Thus it’s important to note that if you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker.
Test for Determining Independent Contractor Status
It’s critical that you correctly determine whether the individuals you hire are independent contractors or employees. Generally, you have to withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee.
You do not generally have to withhold or pay any taxes on payments to independent contractors.
To stay out of hot water with the IRS, you need to make sure the workers you classify as independent contractors meet the IRS definition of an independent contractor.
The basic test for determining whether a worker is an independent contractor or an employee is whether the principal has the right to direct and control the manner and means by which the work is performed. By the way, the principal refers to the boss, the manager, or the employer.
When the principal has the “right of control,” the worker will be an employee even if the principal never actually exercises the control. If the principal does not have the right of direction and control, the worker will generally be an independent contractor.
Common Law Rules dictate that the degree of control and independence fall into three categories:
- The first is Behavioral. This element asks where the business controls or has the right to control what the worker does and how the worker does his or her job.
- Second, Financial: this element analyzes where the business aspects of the worker’s job are controlled by the payer? This includes factors such as how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc.
- And third, Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Also, is there a written Independent Contractor Agreement in place?
You must weigh all these factors when determining whether a worker is an employee or independent contractor. It’s important to note that there are no “magic” or set number of factors that make the worker an employee or an independent contractor, and no one factor stands alone in making this determination.
The key is to look at the entire relationship, consider the degree or extent of the right to direct, and control and consider all of the factors in coming up with the determination.
Factor #1: Behavioral Control
The first element we will analyze is Behavioral Control.
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
1. Instructions the business gives the worker
An employee is generally subject to the business’ instructions about when, where, and how to work.
All of the following are examples of types of instructions about how to do work:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What specific work must be performed by the worker
- What order or sequence to follow
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved.
A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
A great question to ask for this element is “Do you instruct or supervise the person while he or she is working?” Independent contractors are free to do jobs on their own way, using specific methods they choose.
A person or firm engages an independent contractor for the job’s end result. When a worker is required to follow company procedure manuals and is given specific instructions on how to perform the work, the worker is normally an employee.
2. The training the business gives the worker
An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
It’s important to know that “control” is the most important factor for employers. The less control exercised over the individual, the more likely they will be considered independent contractors. Also, you may need to limit supervisory powers over the independent contractors as much as possible.
Factor #2: Financial Control
The second test for determining whether a worker is an employee or an Independent Contractor is Financial Control.
Facts that show whether the business has a right to control the business aspects of the worker’s job include:
- The extent to which the worker is reimbursed for business expenses. Independent contractors are more likely to be reimbursed for their expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur reimbursed expenses in connection with the services they perform for their business.
- Second, the extent of the worker’s investment. An employee usually has no investment in the work other than his or her own time. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
- Third, the extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
- Fourth, how the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat-fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
- And lastly, the extent to which the worker can realize a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An independent contractor can make a profit or loss.
A practical tip is to have Independent Contractors use their own tools and resources. You should avoid providing the means and location for independent contractors to perform their work. If it is impracticable for the independent contractors to work from home or their own space, have them pay rent for using the business’s property and resources.
Another tip is to limit the Amount of Training: Training is indicative of an employer-employee relationship. Despite the necessity to fully train and educate newly hired individuals, employers must try to avoid doing this within reason.
Independent Contractors should possess their own skills and should not need full training as an employee would.
Factor #3: Type of Relationship
The last factor is the Type of Relationship.
Facts that show the parties’ type of relationship include:
- Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, a written contract can make a difference.
- Second, whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. A true independent contractor will finance his or her own benefits out of the overall profits of the enterprise.
- Third, the permanency of the relationship. If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
- Lastly, the extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company’s regular business activity, it is more likely that the company will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Of course, do not underestimate the difficulty of applying these standards to specific individuals performing services. In doubtful cases, always consult a knowledgeable business law attorney.
Form SS-8: When You Are Not Unsure Whether Employee or Independent Contractor
If it is still unclear whether a worker is an employee or an independent contractor, you may file Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” with the IRS.
This form is to request a determination of the status of a worker under the common law rules for purposes of federal employment taxes and income tax withholding. Generally, under the common law rules a worker is an employee if the firm has the right to control what will be done and how it will be done.
There is no fee for requesting a Form SS-8 determination letter.
When the IRS receives the request, it will begin research and may come back to the firm and worker for further information. At the end of the process (which might take up to six months) the IRS will either issue a determination letter, which is binding on the IRS, or issue an informational letter, which is advisory but not binding.
Note that Form SS-8 determination may be requested only in order to resolve federal tax matters. The IRS does not issue a determination letter for proposed transactions or on hypothetical situations or for other reasons not in the best interests of tax administration.
Independent Contractor Agreement
Once you’re sure you’re working with Independent Contractors, you need a legal agreement to govern your relationship with the Independent Contractor.
The Independent Contractor Agreement is the most important contractual writing you’ll have between the two most important parties in your business – you and your independent contractors.
I have attached a sample Independent Contractor Agreement to this lesson.
Independent Contractor Agreement is perfect for companies or businesses that are looking to hire independent contractors, freelancers, or consultants on a temporary basis. Hiring an independent contractor is a great way for start-up businesses to acquire a specialized talent that is needed for a temporary assignment.
What Does a Typical Independent Contractor Agreement Include?
All of the details above are their own independent contracts in their own way. In other ways, some lawyers will split all of those into their own contracts and charge you for each of them. I provided a sample comprehensive Independent Contractor Agreement that you can use.
Please note, this contract will not prevent you from getting sued – it will only serve as your defense to help you defend your business. However, the more you do to protect your business early on, the more you’ll be able to save yourself from headache in the long run should a lawsuit occur.
Who Needs an Contractor Agreement?
So who may need a contractor agreement? The answer is really anybody!
Independent Contractor Agreement is perfect for companies or businesses that are looking to hiring an independent contractor on a temporary basis. Hiring an independent contractor is a great way for start-up businesses to acquire a specialized talent that is needed for a temporary assignment.
Independent Contractor Agreement are great for companies, businesses, or entrepreneurs who are looking to hire an independent contractor.
Also individuals who want to make sure that the company owns any intellectual property that is worked on by the independent contractor for the company, and individuals who are looking to clear any confusions about each party’s rights and obligations when it comes to hiring a new employee.
If you’ve made the determination that the person you’re paying is an independent contractor, you also need the the contractor complete Form W-9 which is called the Request for Taxpayer Identification Number and Certification.
This form is used to request the name and Taxpayer Identification Number, or TIN, of the worker. A TIN may be either a Social Security Number (SSN), or an Employer Identification Number (EIN).
The W-9 form should be kept in your files for four years for future reference in case of any questions from the worker or the IRS.
Also, if your worker is a foreign and does not live in United States, then you need W-10 form.
For more information regarding Form W-9, Request for Taxpayer Identification Number (TIN) and Certification, see here.
Form 1099-MISC and Form DE 542
You also need to know about the 1099-MISC Form.
If a worker is an employee under the common law of employment, the business by which the worker is employed must report the worker’s earnings to the Employment Development Department (EDD) and must pay employment taxes on those wages.
If you pay an independent contractor $600 or more in payments, you must file Form 1099-MISC with the IRS and must file a Report of Independent Contractor (DE 542) with the Employment Development Department within 20 days of either making payments totaling $600 or more, or entering into a contract for $600 or more with an independent contractor in any calendar year.
So again, if you pay your independent contractors $600 or more in any calendar year, then you need to fill out and turn in Form 1099-MISC to the IRS and also fill out and turn in Report of Independent Contractor Form 542 to the Employment Development Department. Also, a copy of 1099-MISC must be given to the independent contractor by January 31st of the year following payment.
For more information regarding form 1099-MISC, see here.
Top 3 Tips for Hiring Independent Contractors
Now that we’ve covered all of the essential topics we need to know about independent contractors, there are 3 top tips that we need to discuss before hiring independent contractors.
Tip # 1: Use an independent contractor agreement BEFORE the engagement begins so that your independent contractor is not misclassified as an employee.
Misclassification can create serious legal problems, including audits of the entire workforce by federal and state tax authorities and the imposition of penalties. This is an area of increasing concerns because both federal and state governments are increasing efforts to investigate employee misclassification issues to recoup lost revenue through penalties.
A worker’s status can affect the rights of the employer to any copyrightable works or patentable inventions created by the worker. For example, employer is generally deemed to be the author of, and therefore the owner of the copyright for, any works created by an employee acting within the scope of employment. Similarly, the employer is the owner of any invention created by an employee “hired to invent.”
In contract, a company commission a work by an independent contractor will not own the copyright unless the company secures either a written contract stating that is a “work made for hire” or a written assignment of the copyright. Similarly, independent contractors own their inventions (and any patents) absent a written assignment of inventions.
So make sure to have your worker sign an Independent Contractor Agreement before he or she starts working for you!
Tip #2: Make sure you treat your independent contractor as a contractor, and not as an employee.
This means that you should control your contractor or micro-manage them. This is true even if you have an independent contractor agreement in place.
We’ve already talked about the various tests of employees versus independent contractors. It’s important to keep all of those factors in mind in how you’re treating your workers. Sometimes how you treat them determines whether they’re considered independent contractors or employees.
Of course, you should always speak with a business lawyer if you have any doubts or questions about the applicabilities of these issues.
Tip #3: Do not leave anything to chance – the terms of your independent contractor should be in writing and in great detail to prove the independency from the company.
You should make every attempt to determine the proper status of the worker before the work relationship begins.
The written independent contractor agreement can be helpful in case of a dispute, in proving that there was a contract, and just what was agreed. Without a written agreement, if the dispute has to go to court, the court will only have each party’s word to assist it in working out what happened.
So always make sure you have your independent contractor agreement in writing and have your worker sign and date the contract before you begin any work with the worker.
Have Questions About Hiring Independent Contractors?
Mollaei Law is a law firm specializing in business law serving businesses and entrepreneurs. We provide legal expertise in all stages of business development by drafting and reviewing contracts and agreements, assisting transactions and negotiating, forming LLC’s and Corporations, registering trademarks and copyrights, business planning, and answering any legal questions you may have about your business.