Distinguishing between employees and independent contractors constitutes a crucial determination that can significantly impact business operations.

When a business hires independent contractors, it avoids certain taxes and isn’t required to provide the same benefits provided to employees. This can result in substantial cost savings — usually
30 percent to 40 percent on labor expenses. In addition, hiring contractors for specific projects or durations helps businesses avoid the hassle of repeatedly hiring and training new employees once a job is complete.

Businesses must remain wary, though, of classifying individuals as contractors. Misclassification can lead to serious financial and legal consequences. The U.S. Internal Revenue Service requires companies to provide contractors with a 1099 form if they’ve paid them $600 or more during the year and could report these payments using a 1096 form. The IRS and U.S. Department of Labor monitor whether companies comply with the rules regarding employee and contractor classification, often conducting audits to ensure adherence.

Companies found in violation of misclassifications can face penalties that include:

Retroactive payment of back taxes for the individual.

Interest calculated from the time payments were due.

Penalties of up to 100 percent of the amount due.

Retroactive contributions to Medicare and Social Security as well as payment of federal and state unemployment taxes and worker’s compensation.

Retroactive contributions to a worker’s retirement fund also could be necessary.

It’s important to understand the differences between an independent contractor and employee. Generally, if an employer exerts significant control over how someone works, that person is considered an employee. With independent contractors, employers typically only oversee the final outcome of the work, not the process itself.

Employers don’t usually manage the day-to-day tasks of independent contractors the way they do with employees. They don’t provide needed tools or supplies for a job. Employers exert more control over employees, dictating not only the tasks but also the methods and tools used.

Another critical difference lies in compensation. Independent contractors are usually paid based on fulfilling the terms of contracts, with employers retaining the right to refuse payment if terms aren’t met. Withholding wages without a valid reason is often illegal when it comes to employees.

The Department of Labor uses an economic realities test to determine worker classification. This test assesses various factors to understand the nature of the working relationship, including control, opportunity for profit or loss, skill and initiative, permanence of the relationship, integration into the business and degree of independence.

The IRS employs a three-pronged test — known as the common law test — focusing on behavioral control, financial control and the type of relationship between the worker and the employer.

While hiring an independent contractor provides many advantages to companies, it’s important employers document and update records that can prove an individual’s status as a contractor. It’s essential for employers to have an independent contractor agreement containing a description of the services the individual will perform, how long the project should take and how the person will be paid. This agreement can serve as evidence of the person’s status with the employer.

Employers also should consider screening independent contractors before hiring them to complete a project. Use a formal interview questionnaire to collect the information needed to verify the person’s status as an independent contractor. Here are a few questions to ask:

Do you have a legal entity established for your business?

Do you hold professional licenses?

What type of equipment and supplies do you own to complete the project?

What insurance coverage do you have in place to cover your business?

Can you provide professional references?

When an employer exerts more control, it’s less likely someone will be considered an independent contractor.

Proper classification of workers ensures legal compliance and the appropriate protection for workers while also allowing businesses to operate efficiently.
If uncertainty persists, seek clarification from the IRS.