The Problem:

One day three business owners, Bob, Sheila, and Ed, did lunch at their favorite restaurant. Over turkey sandwiches and tossed salads, they began to share notes on their latest employee/contractor strategies.

Bob was trying to cut costs. He decided to convert some of his workers to independent contractor status from employee status. In doing so, he reduced payroll taxes, FICA contributions, workers compensation premiums and health insurance premiums. Bob was happy.

Sheila had been approached by a highly sought after executive who agreed to provide services on a "contract basis" only. Delighted that this prominent executive selected her company, the Sheila agreed to pay the executive on a contract basis. Sheila knew that if she was not accommodating, the high flying executive would go to work for a competitor. The executive came to work for Sheila. Sheila was happy.

Ed treated all workers as independent contractors for the first six months of employment. Due to heavy turnover during those initial months, Ed thought it would be cost effective to pay the workers on a 1099 basis as opposed to putting them on payroll. The company was able to reduce the substantial paperwork involved in taking employees on and off the payroll. Ed was happy.

Bob, Sheila, and Ed thought they were making prudent business decisions: cutting business costs in the form of reducing payroll and benefits expenses; accommodating high level contractors who would otherwise go to work for a direct competitor, and improving efficiency.

Then the IRS called. Bob, Sheila, and Ed were no longer happy.

The Reason:

Only certain individuals may legitimately be treated as independent contractors. Contrary to popular belief, the mere existence of an independent contractor agreement or freedom from direct supervision will not, by itself, create an independent contractor relationship.

There is a distinct difference between an employee and an independent contractor:

An employee is a worker who performs a service for an employer, who receives a salary or hourly wage and benefits, who is controlled by the employer, who can be fired at will and who performs duties under general or direct supervision.

An independent contractor is an individual who provides a specialized service for an unrelated company, is paid by the job, receives no benefits or expense reimbursement, is not controlled as to the performance of the job and cannot be fired at will.

Certain types of workers must be treated as employees, regardless of the perceived degree of independence. For example, officers of corporations, food and laundry drivers, full time traveling or city sales people who sell goods for re-sale, full time life insurance agents working mainly for one company, at-home workers, artists and authors under collective bargaining or commissioned work and non-licensed construction workers and property managers. Exempt employees are workers who must be treated as employee for certain purposes but not for others, such as direct sellers, licensed real estate agents and corporate directors.

Presently, an individual may be treated as an independent contractor if:

1. the hiring firm has treated that worker and all similar workers as independent contractors
2. the hiring firm has filed all necessary 1099 forms
3. if the hiring firm has a reasonable basis for treating the worker as an independent contractor. However, to achieve this status, you must show actual industry practice or evidence of prior IRS audit where the IRS auditor did not reclassify the 1099 workers.

Why?

Over the last couple of years, the state and federal taxing authorities have launched an aggressive attack on businesses using independent contractors. Audits of these companies have increased substantially and workers who were improperly classified as independent contractors are reclassified to employee status. Both agencies consider independent contractors a tremendous source of untapped income for the government. And indeed, it has been a lucrative effort for the state and federal agencies.

The IRS has published common law factors that are used to determine if a worker is an employee or an independent contractor. Note that it is not necessary to meet each and every one of the common law factors.

Under the common law factors, the contractor must:

1. Be free from instruction
2. Be self-trained, be able to send in substitutes
3. Perform a separate and distinct service not offered by the hiring firm
4. Set his or her own hours
5. Have a limited relationship with the hiring firm
6. Pay his own assistants
7. Have sufficient time to perform work for others
8. Control when and where work is performed
9. Set priorities for own work
10. Be free from reporting requirements
11. Be paid by the job
12. Work for multiple firms doing the same kind of work
13. Provide his own tools and equipment
14. Pay his own expenses
15. Have a significant investment in his or her business
16. Offer services to the general public
17. Have an opportunity for profit or loss
18. Be free from the risk of termination at will.

In addition, the agencies have given weight to whether or not the contractor:

1. Has a separate and distinct business
2. Is highly skilled
3. With the hiring firm understands the nature of the relationship as being independent
4. Has a business license, insurance, business cards, printed invoices and all the trappings of a legitimate business.

The Solution

Businesses who use independent contractors must examine existing relationships to determine if they are indeed legitimate. An exercise that may be worthwhile would be to create a list of all 1099 recipients, their identification numbers, nature of service provided, amount paid during the previous and current year, and the basis for treating them as an independent contractor. For each independent contractor that is legitimately being treated as such, it is a good idea to have a contractor file set up with the job bid, the contract, invoices, the contractor's business card, a flyer or advertisement, evidence of insurance and other documents. In addition, the hiring firm MUST:

1. Hire only contractors who are independently established businesses.
2. Find the contractor through ads or referrals, not help wanted ads.
3. Have the contractor bid on the work.
4. Create a written contract for services for each engagement.
5. Pay the contractor with an invoice only.
6. Rent space to the contractor at fair market rates only, if at all.
7. Prohibit the contractor from using your company name on his business cards.
8. Refuse to provide salary, benefits, expenses, bonuses or parking spaces to the contractor.
9. Refrain from including the independent contractor in company policies.
10. When in doubt, treat the worker as an employee.

Most importantly, businesses should not be fooled into thinking that using independent contractors will result in any cost savings at all. To the contrary. Businesses that get audited for the suspected misuse of independent contractors end up paying substantial fees to lawyers and accountants, spend numerous hours preparing documents in their defense and several months and hundreds of hours tied up in audits. In addition they usually end up owing past due taxes, penalties and interest. Furthermore, when multiple workers are reclassified to employee status, business pension plans may be disqualified and overtime liability may be substantial.

When you look at it that way, treating workers properly from the start is really the most cost effective and prudent way to go.