Hiring Independent Contractors: Know the Pitfalls
Independent contractors and freelancers, or independent specialists, represent a rapidly expanding category of entrepreneurship. Contractors have specialized skills in a given field and work independently, selling their expertise by the hour rather than working as traditional corporate employees.
Traditional employees come with overhead: healthcare benefits, employment taxes, HR compliance, training, paid time off, and often much more. There’s nothing wrong with any of this as long as your employees are necessary for delivering your firm’s core competency. In other areas, however, it may make more sense to outsource specialized, non-core tasks to independent contractors. Done right, outsourcing can give you access to high-quality experts at a lower total cost.
Before hiring an independent contractor, there are a few important issues to bear in mind:
- Defining Independent Contractor Status. In legal terms, an individual is not deemed to be an independent contractor merely because the position is not full-time or because it is for a limited term. The exact criteria defined by the IRS and the Fair Labor Standards Act are quite complicated, and can also vary considerably by state. California, for example, began imposing tight restrictions on who can be considered an independent contractor starting in 2000. One important distinction is that independent contractors have control over their time and their work. In other words, you can’t tell a contractor when or how they work. Misclassifying an employee as a contractor can have expensive repercussions for a business owner. You may be required to pay back wages (including overtime); pay back taxes and fees for federal and state income taxes, Social Security, Medicare, and unemployment; and provide employee benefits, including health insurance, retirement, etc. The IRS has been enforcing rules governing independent contractor employment more strictly in recent years, and state audits are even more common, usually initiated when an independent contractor files for unemployment compensation. For more precise information about employee vs. contractor designation, consult the IRS and your state labor department. If you’re still unsure, you can file Form SS-8 to have the IRS to determine the status for you; but you’ll have to wait about six months for their answer.
- Signing Independent Contractor Agreements. Any time that you hire a contractor, it’s a good idea to develop a written agreement to clearly define the parameters of the relationship, which can prevent later disputes and be useful in the case of an audit. The written agreement should refer to the worker as a “contractor” and should describe the services to be performed, the defined term during which they are to be performed, and the amount of the “contract payment” (not wages). The agreement should not require the contractor to work full-time and should clearly indicate that the contractor is not prevented from taking on other work. A sample agreement can be found here.
- Understanding Taxes. As an employer, it can be cumbersome and expensive to hire an employee. You are required to withhold income tax and Social Security and Medicare taxes from an employee’s paycheck. You are also required to pay half of the Social Security and Medicare taxes and various federal taxes (e.g., unemployment and payroll) in addition to state and local unemployment and worker compensation taxes. By contrast, with an independent contractor, the tax burden lies with the contractor, not the employer. Your obligation is only to issue a 1099-IC to any contractor paid more than $600 in a year. It is the contractor’s responsibility to pay all taxes.
These are just a few highlights. For more information and links to additional resources, read the IRS’s guide Independent Contractor (Self-Employed) or Employee? You should also consult with your attorney.