Small Business Solutions - FAQ for Firms Hiring Independent Contractors

FAQ for Firms Hiring Independent Contractors

Article by Stephen Fishman
Copyright © Nolo Press 1998
Stop by their site to read other articles from the "self-help law center."

1. What is an independent contractor?

Independent contractors, or ICs, are people who contract to perform services for others but don't have the legal status of employees. Businesses can save time, money and headaches by hiring ICs instead of employees. .

ICs may call themselves by a variety of names--self-employed, consultants, entrepreneurs or business owners--it makes no difference in the eyes of the law.

2. What are the benefits of hiring independent contractors?

Businesses can usually save money by hiring ICs instead of employees. In addition to salaries or other compensation, employers usually must pay employee expenses such as:

federal payroll taxes, including a 7.65% Social Security tax and a usually small (.08%) federal unemployment insurance tax
state unemployment insurance premiums
workers' compensation insurance premiums
employee benefits such as health insurance, paid vacations, sick leave, retirement benefits and life or disability insurance, and
office space and equipment.

These expenses add at least 20% to 30% (often more) to payroll costs. For example, if you pay an employee $10 per hour, you will probably pay another $2 to $3 per hour in employee expenses. You incur none of these expenses when you hire an IC. So even though ICs are often paid more per hour than employees doing the same work, they still cost less.

In addition, when you hire ICs instead of employees you have reduced exposure to some types of lawsuits, such as those alleging job discrimination or wrongful termination.

Finally, and most important for many firms, ICs provide a level of flexibility that can't be obtained with employees. You can pay an IC to accomplish only a specific task, allowing your business to get specialized expertise for a short period. You need not go through the trauma (not to mention potential severance costs and lawsuits) of laying off or firing an employee. Moreover, an experienced IC can be productive immediately, eliminating the time and expense involved in training employees.

3. What are the Risks of Hiring Independent Contractors?

Despite the advantages, many businesses are terrified of using ICs because they have heard about or experienced the consequences of misclassifying as ICs workers who are, legally, employees. And it's true that the consequences can be economically devastating. A business must pay the IRS all back taxes owed, with interest, plus a penalty of 12% to 35% of the tax bill.

Audits by state agencies are even more common than IRS audits. State audits most frequently occur when workers classified as ICs apply for unemployment compensation after their services are terminated. An investigation by your state unemployment compensation agency will ensue, and you will be subject to fines and penalties if it is determined that workers should have been classified as employees for unemployment compensation purposes.

Another major disadvantage of hiring ICs is that they can sue you for negligence if they are injured on the job. This is something employees covered by workers' compensation normally cannot do.

4. When do Workers Qualify as Independent Contractors?

Most people who qualify as independent contractors follow their own trade, business or profession-that is, they are in business for themselves. This is why they are called "independent" contractors. They earn their livelihoods from their own independent businesses instead of depending upon an employer.

Good examples of ICs are professionals with their own practices like doctors, lawyers and accountants. For example, dentists who have their own practices are independent businesspersons offering dental services to the public; although you pay your dentist for work, he or she is not your employee.

A worker doesn't have to be a professional, however, to be an IC. A person you hire to paint your office or mow your lawn can be in business for himself or herself and qualify as an IC.

5. What Legal Tests are Used to Determine Whether Workers are ICs or Employees?

There is no single, clear-cut test for classification. Different legal tests for determining worker status are used by various government agencies, including:

the Internal Revenue Service
state unemployment compensation insurance agencies
state workers' compensation insurance agencies
state tax departments
the United States Labor Department
the National Labor Relations Board.

Each of these agencies is concerned with worker classification for different reasons, and has different biases and practices. Each agency normally makes classification decisions on its own and need not consider what other agencies have done, though they are often strongly influenced by it. As a result, it's possible for one agency to find that a worker is an IC and another that he or she is an employee. It's also possible, though rare, for a worker to be deemed an IC in one state and an employee in another.

6. What Test does The IRS Use?

The IRS uses the common law right of control test to determine worker status. Under this test workers are employees if the people they work for have the right to direct and control them in the way they work--both as to the final results and as to the details of when, where and how to work.

In contrast, ICs are not controlled by the firms that hire them. A hiring firm's control is limited to accepting or rejecting the final results an IC achieves.

7. How does the IRS Measure Control?

The IRS has developed a list of 20 factors it uses to measure control under the common law test. These include whether a worker:

can earn a profit or suffer a loss from the activity
is told where to work by the hiring firm
offers his or her services to the general public
can be fired by the hiring firm
furnishes the tools and materials needed to do the work
is paid by the job or by the hour
works for more than one firm at a time
has a continuing relationship with the hiring firm
invests in equipment and facilities
pays his or her own business and traveling expenses
has the right to quit without incurring liability
receives instructions from the hiring firm
is told in what sequence or order to work by the hiring firm
receives training from the hiring firm
performs the services personally
hires and pays assistants
sets his or her own working hours
works full-time for the hiring firm
provides regular oral or written progress reports to the hiring firm
provides services that are an integral part of the hiring firm's day-to-day operations.

Note: The IRS has recently issued a new training manual discussing the 20-factor test. The manual deemphasizes some factors that were formally considered important. For more information, see Chapter 6 of Hiring Independent Contractors: A Legal Guide

8. What Other Legal Tests are Used?

State workers' compensation, unemployment compensation and tax agencies use various tests to determine worker status. Many use the common law right of control test, but emphasize different factors than the IRS. Some use an economic reality test that focuses on whether a worker is economically dependent upon a hiring firm.

Many state unemployment compensation agencies use a special statutory test, also called the ABC test. This test focuses on just a few factors:

whether the hiring firm controls the worker on the job
whether the worker is operating an independent business, and
where the work is performed--that is, where the hiring firm says or where the worker wants to work.

9. Should Hiring Firms Use Written IC Agreements?

Absolutely. An oral agreement isn't worth the paper it's printed on. Using a written agreement avoids later disputes by providing a written description of the services the IC is to perform, when they are to be performed and how much the IC will be paid.

A written IC agreement can also help establish a worker's IC status. Although an agreement by itself is never enough to make a worker an IC, it will help show the IRS and other agencies that both you and the worker intended to create a hiring firm-IC relationship, not an employer-employee relationship. Newly published IRS training materials state that where all the other factors are evenly balanced, a written IC agreement may tip the scale to the IC side.

But remember, an IC agreement is only useful if it's obeyed. It will be useless if you treat a worker like an employee.

10. What About Intellectual Property Ownership?

When you hire an IC to create a work of authorship such as a computer program, written work, artwork, musical work, photographs or multimedia work, you need to be concerned with copyright ownership.

The copyright laws contain a major trap for the unwary--they say that unless the work an IC creates falls into one of nine categories, the hiring firm will not own the copyright to the IC's work unless it obtains a written assignment of copyright ownership. An assignment is simply a transfer of copyright ownership. It should be obtained before an IC starts work. This assignment should be included in the IC agreement.

Certain specially commissioned or ordered works by ICs are considered to be works for hire to which the hiring firm automatically owns all copyright rights. However, both you and the IC must both sign an written agreement stating that the work is made for hire. Again, this should be included in the IC Agreement.

These works include:

a contribution to a collective work--for example, a work created by more than one author, such as a newspaper, magazine, anthology or encyclopedia
a part of an audiovisual work--for example, a motion picture screenplay
a translation
supplementary works-- for example, forewords, afterwords, supplemental pictorial illustrations, maps, chats, editorial notes, bibliographies, appendixes and indexes
a compilation--for example, an electronic database
an instructional text
a test
answer material for a test, and
an atlas

Small Business Solutions, values that make the difference.