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Misclassifying
Employees as Independent Contractors ... One of the Most
Expensive Mistakes of Them All
©
2001 Elena Fawkner
The
time comes for every successful home-based business owner when
one person can no longer do it all. In the early days of
your fledgling business you accepted that not only were you CEO,
CFO, COO, secretary, treasurer and marketing director, you also
had to be laborer, receptionist, janitor, chief cook and
bottlewasher. That is simply what you have to do when
starting out. In fact, I'll bet you worked harder in your
"little home business" than you ever did in your
former life as corporate whatever, right? But now the time
has come. You have successfully taken your business past
the initial, maddeningly slow, frustrating start-up phase to the
point where you're seeing some growth ... so much growth in fact
that you're finding it near impossible to keep all the balls in
the air.
The time has come to hire some help. OK, but what kind of
help do you need? If it's a secretary/receptionist, that's
easy. You go out and hire yourself a competent employee.
But what if it's someone to carry out specific projects such as
designing a website for a good customer you just can't service
within the timeframe the customer needs? What if it's
someone to create a marketing program to launch your business to
the masses? What if it's a bookkeeper to handle your
accounts payable, receivable and everything else in between?
The difference between these types of activities and our
secretary/receptionist example is that the former are all
specific projects whereas the latter is not.
When considering whom to hire for your project work, you have a
choice ... hire a full-time or part-time employee or hire an
independent contractor. By the time you include all the
add-on costs of hiring an employee (in addition to wages or
salary you need to add on federal and state payroll taxes,
social security tax, federal unemployment insurance tax, state
unemployment insurance, workers' comp premiums and employee
benefits, not to mention shelling out for office space and
equipment), hiring an employee becomes a relatively expensive
option compared to hiring an independent contractor to do the
same work. The add-on costs of hiring an employee usually
add about 30-40% to the bill. In other words, if you pay
your employee $10 an hour, you'll really be paying $13 - $14 an
hour once you include all the add-on expenses.
In contrast, although you usually pay an independent contractor
more than an employee, that cost will still be less than an
employee with the add-on expenses. You may pay an
independent contractor $12 an hour without any additional
charges. Sound good? Well, read on. It's not
as easy as it looks.
WHAT IS AN INDEPENDENT CONTRACTOR?
So, what is the difference between an employee and an
independent contractor anyway? Quite simply, an
independent contractor is someone who contracts with someone
else to provide specified services for a set price on terms and
conditions outlined in the contract.
For example, let's say you hire a gardener to mow your lawn and
get rid of weeds once a week. Your contract (whether
written or not) is that Joe Gardener will arrive at your house
on Friday morning, mow your lawn, get rid of weeds and generally
tend to your garden. In exchange, you agree to pay Joe $40
for this service each week. Joe supplies his own lawnmower,
hedge clippers and weeding tools. Joe decides what time he
arrives and how long the job takes (within reasonable
parameters). You do not supervise Joe in his tasks or
dictate to him how they are to be done. Joe is an
independent businessperson and you treat him accordingly.
The final product is either to your satisfaction or it isn't.
When he's finished, you pay him if you're satisfied with the end
result and you don't pay him if you're not.
Contrast this with an employer/employee situation. Let's
say you own the business Joe's Gardening Service. You
employ three employee gardeners to perform services for your
business. As the gardeners' employer, you pay them a fixed
wage and you withhold taxes, unemployment insurance and various
other benefits from their wages to remit to the appropriate
government agencies. In addition, you provide your
employees with the tools and equipment they need to perform
their work. You tell them what to do and supervise them
while they're doing it. At the end of the job they get
paid by you whether your customer is satisfied with the job or
not. In other words, although your customer may not pay
you (the independent contractor) because she is dissatisfied
with the work performed by your employees, you must still pay
your employees because they are not independent contractors -
they are your employees and are entitled to be paid a fixed
wage. If you are dissatisfied with their work, you can
fire them but you can't decide whether to pay or withhold their
wages based on the end result of the particular project.
ADVANTAGES OF INDEPENDENT CONTRACTORS
=> Cost
As mentioned above, the main advantage of independent
contractors versus employees is cost. You can get the same
or better service from independent contractors for a lower
hourly rate than you can from employees because you don't have
to incur all the add-on expenses that go along with hiring
employees.
=> Equipment and Materials
In addition, you don't have to provide office space or
materials and equipment to independent contractors. As
independent contractors (who may also go by the terms
"freelancers", "consultants",
"self-employed", "business owners" etc.) are
self-employed business people, they have their own "tools
of the trade". If they're website designers, they
have their own office space, computer and printing equipment.
If they're gardeners, they have their own lawn mower,
whipper-snipper, wheelbarrow and pruning shears.
=> Legal Liability
At law, an employer is vicariously liable for the torts of
his or her employees. This means that if you hire an
employee gardener who accidentally runs over your customer's pet
cat in the driveway of her home when the customer had made it
clear that your employees are always to park in the street, in
addition to suing your employee for negligence, she can also sue
you, the employer, as you are vicariously responsible for the
acts of your employees. (And, by the way, this applies
whenever your employee is acting within the scope of employment,
whether under your express instruction or not. If your
employee has a car accident when traveling between jobs and his
negligence at least partially caused the accident, you're
responsible to the same extent as the employee.)
This is generally not the case with an independent contractor
unless the independent contractor has been engaged to perform an
inherently dangerous activity (such as blasting) or you have
attempted to delegate to your independent contractor a
non-delegable duty (such as keeping a rental property you own in
good repair for the benefit of the tenant).
In addition to minimizing legal liability for torts, hiring
independent contractors also minimizes your liability for other
types of lawsuits such as wrongful termination or job
discrimination.
DISADVANTAGES OF INDEPENDENT CONTRACTORS
There are two main disadvantages to hiring independent
contractors versus employees.
=> Misclassification
Far and away the most serious disadvantage is if you
misclassify employees as independent contractors. Merely
labeling a worker as an independent contractor is not enough.
They must actually be an independent contractor.
If you do misclassify an employee as an independent contractor,
you must pay the IRS all back-taxes owed, plus interest, plus
penalty (12% - 35% of the total tax bill). Also, you
expose yourself to an increased risk of state audits when your
terminated independent contractor files for unemployment
benefits. Never mind that you and your independent
contractor intended that there be no employer/employee
relationship, many's the disgruntled independent contractor who
unilaterally decides to recategorize the relationship as one of
employer/employee when the spectre of unemployment benefits
raises its pretty head. In such situations, you'd better
be able to protect yourself by proving that the arrangement was
for an independent contractor and not an employee.
=> Legal Liability
Unlike an employee who is limited to workers' compensation
benefits, an independent contractor can sue you for negligence
if they're injured on the job. That's what liability
insurance is for though.
DETERMINING WHETHER JOE IS EMPLOYEE OR INDEPENDENT
CONTRACTOR
Unfortunately, as far as the various government agencies are
concerned, there is not one single test that determines whether
Joe is your employee or an independent contractor. Even
more difficult, it is quite possible that for the purposes of
one government agency Joe is considered to be an independent
contractor while for another he is treated as an employee.
=> The IRS/Common Law "Control" Test
The IRS follows the common law "control" test for
determining whether someone is an employee or independent
contractor. This test looks at 20 factors as being
indicative (and only indicative) of whether the person is an
employee or independent contractor. The test basically
involves a balancing of these factors -- which way does the
scale tip?
Here are the IRS factors:
1. Whether the worker can earn a profit or suffer a loss from
the activity (if so, the more likely it is that the worker is an
independent contractor).
2. Whether the worker is told where to work (indicative of
employee status).
3. Whether the worker offers his or her services to the general
public (indicative of independent contractor status).
4. Whether the worker can be fired by the hiring firm.
5. Whether the worker furnishes the tools and materials needed
to do the work (indicative of independent contractor status).
6. Whether the worker is paid by the job or by the hour
(independent contractors are more likely to be paid by the job;
employees by the hour).
7. Whether the worker works for more than one firm at a time
(indicative of independent contractor status).
8. Whether the worker has a continuing relationship with the
hiring firm (indicative of employee status).
9. Whether the worker invests in equipment and facilities
(indicative of independent contractor status).
10. Whether the worker pays his or her own business and
traveling expenses (indicative of independent contractor
status).
11. Whether the worker has the right to quit without incurring
liability (indicative of employee status).
12. Whether the worker receives instructions from the hiring
firm (indicative of employee status).
13. Whether the worker is told how to perform the work
(indicative of employee status).
14. Whether the worker receives training from the hiring firm
(indicative of employee status).
15. Whether the worker performs the services personally.
16. Whether the worker hires and pays assistants (indicative of
independent contractor status).
17. Whether the worker sets his or her own working hours
(indicative of independent contractor status).
18. Whether the worker provides regular progress reports to the
hiring firm.
19. Whether the worker works full-time for the hiring firm
(indicative of employee status).
20. Whether the worker provides services that are an integral
part of the hiring firm's day-to-day operations (indicative of
employee status).
It is important to note that none of the above factors are, of
themselves, determinative. The IRS will balance all of the
factors to determine which side of the equation is favored.
=> Other Agencies
The other government agencies with which you need to be
concerned are:
1. Your state Unemployment Compensation Board.
2. Your state Workers' Compensation Insurance Agency.
3. Your state Tax Department.
4. Your state/federal Department of Labor.
Unfortunately each state agency varies in its approach to
determining whether a worker is an employee or independent
contractor. Many states' agencies use a statutory test
focusing on just a few of the "control" test factors.
You should therefore find out the factors that your state's
agencies take into account before hiring any independent
contractors. Most of this information will be available on
the agency's website. If not, call them and get them to
send you information about their policies.
PROTECTING YOURSELF
OK, so you know the difference between an independent
contractor and an employee, you know the advantages and
disadvantages of hiring independent contractors and you know the
dangers of misclassification. How do you protect yourself?
=> Independent Contractor Agreement
First and foremost, arm yourself with the IRS' control test
factors and the tests used by the various government agencies in
your state. Once you have that information, you can
structure your arrangements with your independent contractors
accordingly. These arrangements should be reduced to
writing, in the form of an independent contractor agreement.
An independent contractor agreement should contain a description
of the services the independent contractor is to perform, by
when they are to be performed and the amount the independent
contractor is to receive in return for satisfactory service.
This agreement can be very helpful evidence in proving that the
worker's status was independent contractor rather than
employee. Although such an agreement is insufficient by
itself (if you nonetheless treat the independent contractor as
an employee the agreement will be worthless for this purpose),
if the factors weighed by the IRS under the control test are
evenly balanced, an independent contractor agreement may well
tip the scales in your favor.
=> Screening
Before hiring an independent contractor, put him or her
through a few hoops first. It's a good idea to prepare
some form of questionnaire to extract the sort of information
you would need to be able to prove in support of your argument
that the worker is, in fact, an independent contractor and not
an employee. Examples of such information (courtesy of the
NOLO website - http://www.nolo.com)
include:
1. Whether the worker has formed a legal entity for his or
her business.
2. Whether the worker has filed a fictitious business name
(also known as a "DBA" or "doing business
as").
3. The worker's business address and telephone numbers.
4. The number of employees employed by the business.
5. Whether the worker has any professional or business licenses.
6. References from other business for whom the worker has
performed services as an independent contractor.
7. How the worker markets his or her business.
8. Whether the worker maintains an office separate from
his or her home.
9. A description of the equipment and facilities the
worker owns and will use in the project.
10. Whether the worker has business cards and stationery
etc...
11. A listing of the types of insurance coverage the
worker has for his or her business.
Request documents that evidence the responses to the above
questions. For example, get copies of fictitious business
name statements, professional and business licenses; references;
business cards and stationery and insurance policies.
At the end of the day, whether you hire an employee or an
independent contractor is a decision for you and your business.
If you feel you can adequately protect yourself against an
allegation of misclassification then, by all means, follow the
independent contractor route if that makes most sense to you.
But if you don't feel confident in managing the relationship to
protect yourself from such a charge, for your own peace of mind,
you may be well advised to hire an employee even if that is more
expensive up-front. After all, if you get it wrong, you'll
be paying those additional costs anyway in the form of
back-taxes (and interest and penalties to boot).
Elena
Fawkner is editor of A Home-Based Business Online ... practical
ideas, resources and strategies for your home-based or online
business.
http://www.ahbbo.com
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