Beware, The Contractor Trap

Independent contractors can give you flexibility and save you money, but there are risks. How not to get burned.

For many small businesses, hiring independent contractors seems like the ultimate no-brainer. Because they’re considered by the IRS to be in business for themselves, independent contractors aren’t, technically, employees. As a result, companies don’t have to pay any state or federal payroll taxes. Nor are they required to provide benefits, from worker’s compensation to overtime to health insurance. Plus, it’s easier to hire or fire them, a big plus for industries with seasonal fluctuations. “It helps small businesses to be faster on their feet,” says Steven Stimell, an attorney with Bryan Cave in New York, who specializes in employment law.

But small business owners can also land in a heap of trouble if they don’t know the sometimes arcane rules that the IRS uses to determine who is a contractor and who is an employee. A company that gets it wrong can wind up paying not only back taxes and penalties, but also all the expenses that the worker would have had as a fulltime employee, including overtime and benefits. When the IRS does find out, the cost is typically $20,000 to $30,000 per employee, according to Laura Worsinger, senior counsel for Buchalter, Nember, Field & Younger, a Los Angeles-based law firm.  Plus, an investigation of one case can pique the IRS auditors’ interest—and inspire an investigation of all your tax practices.

Determining whether or not someone is legitimately an independent “is an art, not a science,” says Worsinger.  The IRS publishes a list of rules. that businesses must meet, most of which focus on how much control the company exerts over an individual’s work. If, for example, the company sets the worker’s hours, then he or she probably would be deemed an employee. If the worker can be fired for other than nonperformance of duties specified in a contract, then he might be classified an employee. And if the services provided are “integrated” into the business operation, the IRS might consider the contractor to be an employee. In addition, many states have their own wrinkles. So, it’s easy to make a mistake.

   What to do?

SOME COMMON PITFALLS:

• --Don’t forget to have a written agreement. Have independent contractors sign a contract, stipulating that the individual is being hired as an independent contractor and spelling out the nature of the work that will be performed, how he or she will be paid, and when the work is to be completed.

• Be careful not to file too many 1099s.  For tax purposes, businesses have to file a 1099 form, which tells the IRS how much the independent contractor made, for everyone who earns more than $600. But, if you turn in too many, you might trigger an audit, because the service will suspect that some or all of those workers should be classified permanent employees, according to Stephen Fishman, an attorney and author of Working with Independent Contractors (Nolo Press, 2005).

• Don’t treat the contractor like an employee.  You’re the boss and you can tell an employee what to do, how to do it and when to do it. But the IRS rules stress the “independent” in independent contractor. “You tell them the results they need to achieve, you don’t supervise how they go about achieving them,” says Fishman. That means having contractors provide their own tools and equipment and allowing them to work for other clients while they are under contract to you. It’s also better if the contractor does not work at your office. You can even violate the IRS rules by requiring contractors to attend regular employee meetings or giving them your employee handbook.

• Tread cautiously when using an independent contractor for a long period of time. If someone works for you for, say, several years, but clearly fits the IRS criteria--having other clients and controlling his or her hours, for example—you should be okay, according to Stimell.  On the other hand, “If I retain you for four years and you’re working for me exclusively, that begins to smell a lot more like an employee,” he says. 
• Even if an employee asks to be paid on a 1099—to hide his or her income from a former spouse, say—the IRS can cite you.

The last point brings up another issue for companies hiring temps: Your relationship with a contractor is not the same as with an employee, who counts on you for a paycheck, a career, his family’s health care, and maybe some profit-sharing. Your contractor is not a member of the corporate family.

Worsinger recalls the case of a 50-employee garment manufacturer that hired a highly skilled salesperson, who asked to be paid as an independent contractor. He wanted to hide his earnings from his soon-to-be-ex. Four years later, the company fired the man, who promptly sued, charging that he had been incorrectly paid as a 1099 worker.  The company’s defense—that the employee had requested the contractor arrangement--failed. The IRS said the salesman had functioned as a fulltime employee and the company wound up paying him about $40,000.

The garment maker learned what employment-law experts know: Disgruntled former contractors are the most common source of IRS audits, according to Worsinger. The moral: Your best insurance against running afoul of the IRS may be treating permanent employees as the valuable resources they are—and saving the contracting work for special projects and seasonal help.                                           

        –Anne Field

Anne Field is a business journalist, based in Pelham, N.Y.