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Hiring a Contractor: What To Know

Small businesses rely on independent contractors for almost everything these days. Whether you need someone for a specialized job or an on-call driver, independent contractors are there to fill the need. Small business owners must be careful when hiring independent contractors to avoid trouble with the IRS later.

Although it seems simple enough, hiring freelancers for work rather than hiring employees is different, according to the Internal Revenue Service (IRS) and Equal Employment Opportunity Commission (EEOC). Even if they do the same thing, they are different types of workers. If an employer makes a mistake, known as misclassification, they can find themselves in very expensive trouble.

This article discusses how hiring an independent contractor differs from hiring employees and how to avoid misclassification errors. It also gives tips on what to do in case of a misclassification audit.

Visit FindLaw's Hiring Process section for other articles and resources to guide you through the hiring process.

Hiring an Independent Contractor

When you hire an employee, you have certain expectations. Your employee works for your business. You have a high degree of control over your employees. You set the schedule, although your employees may have some input about their shifts. Your business may have a dress code, or employees must wear uniforms. You must follow federal and state laws regarding employee benefits and workers' compensation.

The independent contractor relationship is different. Employers hire contractors for a particular business need or for a set period of time. Contractors are self-employed and handle their own taxes. You may have some say over when and how a contractor works, but usually the contractor sets their own schedule and performs their tasks on their own time.

An independent contractor is not a temporary worker. Temporary workers are employees of the temp agency. The agency hires them, pays their taxes and schedules, and may provide benefits. Temp workers may come in part-time or full-time to an office, but they are not contractors.

Keeping contractors separate from employees means employers must take a few extra steps during hiring. You may want an independent contractor agreement. These contracts are separate from regular employee contracts and define the contractor-employer relationship. Although the IRS does not consider a written contract absolute proof that a worker is an independent contractor, it is a good first step in the event of an audit.

An agreement or contract should also spell out:

  • Where the work will be done, i.e., at the employer's worksite or the contractor's place of business
  • The time frame for completion, or how long the contract will run. Most independent contracts are short-term agreements for single projects.
  • Whether the employer will provide tools and materials or if the contractor must supply them. If the contractor buys materials, the contract should state if they can bill the employer for costs.

An independent contractor agreement is no different from a house or auto repair contract. It lists what the person will do and their pay rate. Keep this contract on hand in case of a misclassification audit.

How To Avoid Misclassification Errors

Businesses misclassifying full-time employees as independent contractors have recently faced a great deal of IRS and state scrutiny. Part of this came from ride-share companies like Lyft and Uber demanding that people who signed on with their app be available during certain hours and conform to company standards of dress and behavior, just like employees. In California, this led to AB-5 and Prop 22, known as the "Gig Worker" bills.

By misclassifying workers, employers save themselves a little tax money during the worker's employment. They are liable for much more if the worker applies for unemployment or workers' compensation. You can avoid misclassification errors by treating your workers fairly and not intentionally classifying employees as contractors to save a few dollars at tax time.

To avoid accidental or unintentional misclassification, keep the IRS classification standards in mind:

  • If you are unsure about a worker's status, file a Form SS-8. This IRS form lets you describe what the worker will do so the IRS can assess their status. It takes several months to receive a reply from the IRS, so plan accordingly.
  • Ask prospective contractors if they carry their own Social Security and health insurance. As with a contractor agreement, this is not dispositive but helps establish the contractor's status.
  • Limit your control over the contractor's scope of work. All successful cases against employers have been situations where the employer hired contractors and ordered them to follow the same work schedules, dress codes, and performance standards as employees. Shipping giant FedEx has been fighting and losing lawsuits for two decades over this.
  • Periodically self-audit your 1099s and W-2s. If your 1099s go to individuals, check if you have written contracts with them. If they've been with you for a while as contractors, double-check to see if they were ever W-2 employees or vice-versa. If you have a contractor who has worked for your company for a long time doing the same job an employee might do, it might be time to make them an employee.

Federal laws protect their rights and benefits if your employee is not an independent contractor. If they're not receiving those benefits, it can trigger a misclassification audit.

Dealing With an Independent Contractor Audit

Misclassification audits can happen in several ways. If the worker believed they were an employee, the EDD will notice if the worker files an unemployment or workers' compensation claim.

The IRS expects a 1099 filing from all W-9 workers at tax time. When they don't see any from your workers, they wonder why. As many businesses have learned, unhappy workers may complain to the EDD or Department of Labor.

The EDD or IRS will send you notice before an audit, letting you know they believe you have been failing to withhold taxes for the employee. You'll have to prove that the worker is really an independent contractor. Some things you should have on hand include:

  • Your independent contractor agreement. Include the W-9 and the contractor's Social Security number or EIN if they have one.
  • A copy of the independent contractor's business license, if the contractor is a sole proprietorship or LLC.
  • Advertising or links to the contractor's website or social media.

Penalties for Misclassifying a Worker

Federal agencies audit employers because of the lost tax revenue. State agencies audit because misclassification violates state labor laws. Depending on the location of your business, you can face steep penalties if you're found liable for misclassifying workers.

The IRS, EEOC, and state agencies can levy steep penalties for violations. On the federal side, penalties include:

  • A minimum of $50 per unfiled W-2
  • Unpaid wages, including overtime and minimum wage deficits, for instance, if a contractor's agreement did not equate to the state's minimum wage per hour worked
  • 3% of wages paid to improperly classified workers as a penalty for Fair Labor Standards Act (FLSA) violations
  • 40% of the employee's FICA, and 100% of the employer's FICA
  • State fines and penalties. These can range from $5000 to $15,000 per violation, with additional damages for intentional misclassification.

Payroll taxes are expensive for small businesses, but the costs of violation are much higher. If your worker is an independent contractor, treat them as a contractor. You'll have to take out employment taxes and provide other benefits if they are an employee.

Getting Legal Help

Misclassifying independent contractors even unintentionally has serious consequences. If you find yourself facing a misclassification audit, don't try to manage by yourself. Consult a business law attorney or tax attorney near you who knows the state laws about hiring independent contractors.

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