Contractor vs. Employee – What Business Owners Need to Know to Stay Legal

If you own a small business and have independent contractors, you need to make sure these people qualify as independent contractors. If not, you could face a fine between $1,100 and $5,000 per infraction. That means the next independent contractor you hire could be an attorney. Expensive and unnecessary.

Of course, hiring independent contractors is wonderful. They save you a bundle in taxes and benefits. But that benefit evaporates if you run afoul of the IRS. Here’s how to make sure that doesn’t happen.

The IRS looks at three areas relating to how much control you have over the independent contractor.

1. Behavior

Do you have control over what the contractor does and how she does it? If you (as business owner) have direct control over the person, she is an employee and not a contractor. You can make sure the contractor qualifies as a contractor if:

a. She controls when and where to do the work

b. She uses her own tools and equipment

c. She hires her own assistants

d. She decides where to buy supplies and what supplies to buy

To make sure your contractor qualifies, ask her to pay for supplies, to use her own equipment and to hire her own assistants. Also, make sure she controls when and where to get the work done. It will help if she carries her own small business liability insurance too.

Make sure you can document that the contractor makes most of the decisions about the work. The less instruction you give and the less control you have, the better. The bottom line is that you as employer must demonstrate that you’ve given up the right to control your contractor’s behavior.

2. Pay

Another test the IRS uses is the evaluation system. Pay the person on results, not on how the work is done. This strengthens the case that you’ve hired a contractor.

3. Skin in the Game

The next area the IRS looks at is financial. If possible, you want to demonstrate that the contractor has made a significant investment in her business and is not using your equipment. Expenses shouldn’t be directly reimbursed but rolled into the fee being charged.

If you can demonstrate that the person is in business for themselves and has an opportunity for profit or loss, so much the better. At the same time, keep records showing that the contractor looks for other jobs too. Contractors advertise all the time, and you should keep records of those advertisements. On the financial front, you might pay the contractor on an hourly basis, but you’ll be far better off if you can pay the person on a flat fee.

Even if you have a written contract stating the person is a contractor, the IRS doesn’t have to accept it. Also, paying your contractor benefits like health plans and sick days won’t help you prove your case to the IRS.

And just because you don’t provide benefits, it doesn’t mean the person isn’t an employee. You’ll also have a stronger case if you can prove that when the relationship started and that it was for a specific task with a definite end date. If your relationship is indefinite, it may be tough to convince the IRS that your person isn’t an employee.

I believe that with a little bit of ingenuity, you can take steps outlined above to make sure your independent contractor passes muster should the IRS come calling. Just make sure to take these steps now rather than put it off. It’s the cheapest business insurance you can get when you consider the IRS consequences of not doing so.