Continuing our series about hiring, we look at the ins and outs of hiring independent contractors to work with your business. Hiring contractors is a very popular way for small businesses and startups to get the work done without the paperwork and expense of hiring employees. However, many “independent contractors” do not really fit the description and this can cause problems in the long run for the businesses that hire them.
There are several criteria that the federal government looks at to decide whether someone working for you is an independent contractor or an employee:
1) The extent to which the services rendered are an integral part of the principal’s business.
2) The permanency of the relationship.
3) The amount of the alleged contractor’s investment in facilities and equipment.
4) The nature and degree of control by the principal.
5) The alleged contractor’s opportunities for profit and loss.
6) The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
7) The degree of independent business organization and operation.
Per http://www.dol.gov/whd/regs/compliance/whdfs13.htm
This is not a checklist and there is no requirement that the contractor fit every criteria, but this is what needs to be examined to determine if the person providing services is truly an independent contractor.
For example, a founder who has no programming experience hires a software developer to create his product. The services rendered are an integral part of the principal’s business but once the product is developed, the developer’s relationship with the business is over, unless the founder negotiates a separate contract for maintenance support. The developer uses his own equipment at his own home office to develop the product and is paid a fee, negotiated with the founder, to develop the product. The founder does not direct the developer’s day-to-day work and the developer handles his own taxes and withholding. This would most likely be found to be an independent contractor – employer relationship.
However, if we change a couple of conditions, the relationship is completely changed. For example, the founder hires a rising senior computer science major to create the product over the summer and has her working in the founder’s office, using her computer. The founder pays her an hourly rate for the work which she does on her own schedule. The founder doesn’t direct her day-to-day work but expects her to show up several days a week. She handles her own taxes and withholding. In this situation, the developer would most likely be classified as an employee. She does not have an independent business structure and is dependent on the employer to provide a place to work. The employer has not contracted her for a fee but an hourly wage and expects her to show up for work.
Why would the government examine independent contractors’ relationship with their employers? It is unlikely that the government will evaluate these relationships without an invitation from either the contractor or employer, often in the form of the contractor filing for unemployment benefits. At that point, it is up to the employer to prove to the state that both employer and contractor understood that this was an independent contractor-employer relationship. (The first evidence that the contractor did not understand this is that he filed for unemployment benefits.) If there is a written contract, the employer must show it contains the magic words about the contractor being responsible for his own income taxes and withholding. The contractor will be given the benefit of the doubt because it is almost always assumed that the employer is the more sophisticated actor in the relationship.
What are the consequences of an independent contractor being found to be an employee? There are several, depending on which part of the government makes that finding. The Georgia Department of Labor could award unemployment benefits, requiring some additional payments from the employer for unemployment insurance. The Georgia Department of Revenue could require the employer to pay back withholding for state income tax. The IRS could require the withholding taxes for income tax, Social Security and Medicare for the entire time the contractor was employed and the U.S. Department of Labor could require additional payments of wages if what was paid was less than minimum wage. Any or all of the demands for money can kill a startup or small business before it even gets going.
The best way to avoid problems: hire companies or established freelancers as independent contractors and sign a contract that explicitly defines the work and nature of the relationship, including the magic words requiring the contractor to be responsible for their own taxes and withholding. Also, negotiate a fee for the project. There can be contingency clauses for additional requirements, overruns, and maintenance but paying on a per project basis goes a long way toward establishing independence.