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A Guide to Independent Contractors

Small-business owners sometimes need an extra hand. They need someone who can do extra work or who has special skills their business doesn't have. However, their business can't support another full-time employee. Or maybe the job won't take too long, but you can't handle it with the workers you have.

Enter the independent contractor. An independent contractor isn't an employee. They are self-employed specialists who carry out compensated work for a business. Independent contractors work under a separate contract that defines the business relationship.

Hiring an independent contractor can save small businesses time and money. Ensure your relationship is clearly defined. State and federal laws separate employees from contractors. Business owners must know the difference. Read on to learn how and why these distinctions exist.

You can also find other helpful information and resources about small businesses in FindLaw's The Hiring Process section.

Independent Contractors: The IRS

The Internal Revenue Service (IRS) defines independent contractors. Unlike employees, you do not take out payroll taxes from your contractor's wages. Contractors are self-employed and pay their income taxes and Social Security deductions.

The IRS does not have specific guidelines to determine if a worker is a contractor or an employee. Instead, it lists factors employers must consider when employing an individual's services.

Behavioral Factors

Do you have control over what the worker does? Behavioral factors and degree of control include things like:

  • Types and Nature of Instruction: The greater the level of instruction and the more the worker must rely upon the instructions given, the more likely it is that the worker is an employee and not a contractor.
  • Detail of Instruction: If the worker must adhere to the instructions and cannot deviate, they are likelier to be an employee.
  • Training, Especially Ongoing Training: A contract may last a long time, and aspects of the job may change. If the employer wants the job completed in a specific way and trains the worker in that method, the relationship is that of an employer and an employee.

Financial Factors

These factors are those of the contractor. The employer pays for the contractor's work and time. A contractor may have:

  • Unreimbursed Expenses: As independent businesspeople, contractors have costs unrelated to the contract.
  • Possibility of Loss: Contractors risk breach of contract, partial payment, or losing a better opportunity because they are on this job.
  • Equipment Investment: Contractors usually bring their own equipment to a job and take it with them when they finish the project. Although employees in some professions (especially construction) have their own tools, independent contractors bring more tools and materials to a project.

Relationship Factors

The employment relationship between the contractor and the employer is critical. How the parties regard one another matters more than what a written contract says. The IRS is not bound by a written contract stating "This is an independent contractor" if the relationship appears otherwise.

  • Permanence: If the nature of the relationship appears to be indefinite rather than short-term, this is evidence of employee status rather than independent contractor status.
  • Key Aspect of the Business: If the services provided are a key business activity, the employer will want more control over the results and an employee rather than a contractor.

No single factor or specific combination of factors determines who is an independent contractor. Employers must consider these factors when dealing with their workers and outside contractors.

The Department of Labor and the FLSA

The U.S. Department of Labor (DOL) Wages & Hours Division enforces the Fair Labor Standards Act (FLSA). The FLSA sets employees' minimum wages, work hours, and overtime benefits. The FLSA doesn't cover independent contractors but provides substantial protections for employees in misclassification cases.

Unlike the IRS, which focuses on common-law relationship distinctions between the parties, the DOL looks specifically at financial factors. The DOL considers the financial independence of the contractor from the business according to:

  • The degree of control exercised by the employer
  • The contractor's opportunity for profit and loss in the project
  • The contractor's opportunity on the open market is separate from their business participation
  • The reliance of the business on the contractor's services
  • The permanence of the employer-contractor relationship
  • The contractor's investment in facilities and/or equipment
  • The contractor's independent business operation

The DOL considers factors such as the job location, the presence or absence of a written contract, or the time or method of payment irrelevant in determining if the worker is an independent contractor.

Franchisees, volunteers, students, and at-home workers can all be "employees" under the DOL standards. The important factor is whether the worker is independent of the business and can leave and continue working in their field.

State Rules: The ABCs of Independent Contracting

Under the FLSA, states can set wage and hour standards. Federal law provides a floor, not a ceiling. About half the states follow the ABC test when separating contractors from employees. The ABC test simplifies the IRS standards into an easier-to-follow checklist when contract workers began flooding the market during the COVID-19 emergency.

Not all state laws use the full ABC test. In 2019, California enacted one of the narrowest interpretations of the rule in response to Dynamex Operations West Inc. v. Superior Court (2018) 4 Cal.5th 903. The ABC test has three requirements. An employer must meet all three prongs to show a worker is an independent contractor and not an employee.

  • The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
  • The worker performs work outside the usual course of the hiring entity's business.
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

For instance, suppose a bakery was swamped with a need for a designer cupcake maker during the holidays. It hires a cupcake maker to produce 10,000 cupcakes of the maker's design and on their schedule (meeting Prong A). The cupcake maker has an established gourmet cupcake business in town (meeting Prong C).

To avoid the cupcake maker becoming an employee, the bakery must show this work is outside their usual course of business and that the volume and scope of work are different from what they normally produce.

Reasons To Hire an Independent Contractor

Despite the difficulties in determining who independent contractors are, hiring them has considerable benefits. As mentioned, when small businesses need temporary or specialized help, freelancers can fill the void until full-time workers are available. Other good reasons to hire contractors include:

  • Specialized Knowledge and Experience: If you need someone to work for you right now, you don't have time to train a new hire and teach them the job. You need someone who can do the job today with minimal guidance. Of course, that kind of experience doesn't come cheap.
  • Contractors Save You Money: Independent contractors are 1099 employees. That is, you won't need to pay employment taxes, unemployment insurance, or other employee benefits for a contractor. The lower overhead offsets the higher pay demanded by a skilled contractor.
  • Minimal Oversight: You're hiring someone with experience. That means you don't need to watch what they're doing. This frees up your time, often at a premium for small businesses.

Documenting Your Independent Contractor

When it's time to hire someone, there are independent contractor agreement templates online. You can also write your own, keeping the requirements for a contractor in mind. Always have your human resources department or an employment law attorney review your terms before anyone signs them.

Your contractor must complete an IRS form W-9. This gives you their address and Social Security number or EIN. At the end of the year, you file tax form 1099-NEC. This lets the IRS know how much you paid your contractor. The IRS uses this figure to verify the contractor's self-employment taxes and other taxes.

If you're unsure of a worker's status and have time to wait, you can ask the government for help. Fill out and submit IRS form SS-8. A response can take up to six months, and the IRS recommends only onboarding a worker once you've verified their status.

Getting Legal Help

There are important differences between an employee and an independent contractor, even in the age of remote workers and virtual offices. Treating a worker as an independent contractor when they are an employee can be expensive. If you want to ensure your worker is an independent contractor, contact an employment law attorney in your area for advice.

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