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You Are Here: Home - Newsletters - "Organized For A Living" - Article

     Misclassifying Independent Contractors

The time comes for every successful home-based business owner when one person can no longer do it all. Okay, but what kind of help do you need?  If it's someone to carry out specific PROJECTS, you probably don't want to hire a permanent employee. Have you ever considered an independent CONTRACTOR?

An independent contractor is someone who contracts with someone else to provide SPECIFIED services for a SET price on terms and conditions outlined in the contract. You hire Joe Gardener to mow your lawn once a week. Joe supplies his own tools, decides what time he arrives and how long the job takes, and works without supervision. When he's finished, you pay him if you're satisfied with the end result and you don't pay him if you're not.

Contrast this with an employee. You own Joe's Gardening Service and employ three gardeners. You pay them a fixed wage and WITHHOLD taxes, unemployment insurance, and other benefits from their wages. You provide the tools and EQUIPMENT they need, tell them what to do, and supervise the work. At the end of the job, they get paid by you whether your customer is satisfied with the job or not. If you are dissatisfied with their work, you can fire them.

By the time you include all the add-on costs of hiring an employee (taxes, unemployment insurance, benefits, office space, equipment, etc.), hiring an employee becomes an EXPENSIVE option. If you pay your employee $10 an hour, you'll really be paying $13 - $14 an hour once you include all the add-on expenses. Although you usually pay an independent contractor more than an employee, that cost will still be LESS. You may pay an independent contractor $12 an hour without any additional charges.

In addition, you don't have to provide office space or MATERIALS and equipment to independent contractors. As independent contractors are self-employed business people, they have their own "tools of the trade".

At law, an employer is VICARIOUSLY liable for the torts of his or her employees. If your employee gardener runs over your customer's cat in the driveway of her home -- she can sue you, the employer. This applies whenever your employee is acting within the SCOPE of employment, whether under your express instruction or not. This is not the case with an independent contractor -- unless the contractor has been engaged to perform an inherently DANGEROUS activity (such as blasting). Hiring contractors also minimizes your liability for other lawsuits such as wrongful termination or job discrimination. However, unlike an employee who is limited to workers' compensation benefits, an independent contractor can sue you for NEGLIGENCE if they're injured on the job.

If you misclassify an employee as an independent contractor, you must pay the Internal Revenue Service all back taxes owed, plus interest, plus penalty (12% - 35% of the total bill). Also, you expose yourself to an increased risk of state AUDITS if your terminated independent contractor files for unemployment benefits. In such situations, you need to prove that the arrangement was for a contractor and not an employee.

There is not one single test that determines whether Joe is your employee or an independent contractor. The Internal Revenue Service follows the common law "control" test for determining a person's status. This test involves the balancing of 20 FACTORS -- whether the worker:
  • can earn a profit or suffer a LOSS from the activity (contractor)

  • is told where to work (employee)

  • offers his or her services to the general PUBLIC (contractor)

  • can be FIRED by the hiring firm (employee)

  • furnishes the tools and materials needed to do the work (contractor)

  • is paid by the job or by the hour (contractors by the job; employees by the hour)

  • works for more than ONE firm at a time (contractor)

  • has a continuing relationship with the hiring firm (employee)

  • invests in EQUIPMENT and facilities (contractor)

  • pays his or her own business and traveling EXPENSES (contractor)

  • has the right to quit without incurring liability (employee)

  • receives INSTRUCTIONS from the hiring firm (employee)

  • is told how to perform the work (employee)

  • receives TRAINING from the hiring firm (employee)

  • performs the services personally (employee)

  • hires and pays assistants (contractor)

  • sets his or her own working HOURS (contractor)
  • provides regular progress reports to the hiring firm (employee)

  • works FULL-TIME for the hiring firm (employee)

  • provides services that are integral to day-to-day operations (employee)

It is important to note that none of the above factors are, of themselves, determinative. The Internal Revenue Service will balance all of the factors to determine which side of the equation is favored.

The other government agencies with which you need to be concerned are:
  • state Unemployment Compensation Board
  • state Workers' Compensation Insurance Agency
  • state Tax Department
  • state and federal Department of Labor
  Many states' agencies use a STATUTORY test focusing on just a few of the "control" test factors. You should therefore find out the factors that your state's agencies take into account before hiring any independent contractors.

An independent contractor agreement should contain a written description of the SERVICES the independent contractor is to perform, by when they are to be performed and the AMOUNT the independent contractor is to receive in return for satisfactory service.  This agreement can be very helpful evidence in proving that the worker's status was contractor rather than employee.

It's a good idea to prepare some form of QUESTIONNAIRE to determine if the worker is a contractor and not an employee. Examples of such information (courtesy of www.nolo.com) include the worker's:
  • legal business ENTITY

  • fictitious business name (also known as a "DBA")

  • business address and telephone numbers

  • number of hired EMPLOYEES

  • professional or business LICENSES

  • REFERENCES from other contracting clients

  • methods for MARKETING his or her business

  • maintenance of a separate office

  • equipment and facilities to be used

  • business cards and stationery

  • INSURANCE coverage
Request documents that evidence the responses to the above questions. For example, get copies of fictitious business name statements, professional and business licenses; references; business cards and stationery and insurance policies.

If you don't feel confident in managing the contractor relationship to PROTECT yourself, for your own peace of mind, you may want to hire an employee even if that is more expensive up-front. After all, if you get it wrong, you'll be paying those additional costs anyway in the form of back-taxes (and interest and penalties to boot).


Elena Fawkner is editor of A Home-Based Business Online ... practical ideas, resources and strategies for your home-based or online business. Visit her website at www.ahbbo.com.

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