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Independent Contractor or Employee: When You’ve Crossed the Line

Expanding your business is a proud accomplishment in the right direction. On the one hand, your efforts are working and it’s time for more help, but on the other hand, you may have several employment legal questions to consider. Ultimately — it comes down to whether you’re looking to hire an employee or a contractor.

It’s a common chicken-and-egg dilemma you’re facing: is it better to hire employees anticipating that your business will grow, or wait until your business has grown more and then hire employees? Sometimes when you’re just starting out, a full-time employee may not be quite feasible or needed yet. You might instead consider hiring an independent contractor to complete smaller, one-off tasks or to work on specific projects.

Hiring independent contractors instead of employees will allow you to outsource certain tasks, such as managed IT services or bookkeeping, without the expense and administrative burden of setting up W-2 withholdings, benefits, and payments for Medicare, Social Security, unemployment compensation insurance, and worker’s compensation insurance. Additionally, hiring independent contractors increases a business’s flexibility since employers can end their relationship with contractors more easily than with staff employees, and they are not obligated to pay contractors when there is no work.

Many businesses prefer to hire independent contractors because there are often less overhead costs and fewer expenses (i.e. taxes). However, if you incorrectly classify an employee, you’ll be in a mountain of paperwork troubles if you don’t know the difference between the two titles. Let’s break it down.

The difference between a contractor and an employee

This question is not always easy to answer. According to the U.S. Internal Revenue Service (IRS), evidence of the degree of control and independence of a worker falls into three distinct categories:

Behavioral: Does the company control or have the right to control what the worker does and how she performs the job?

Financial: Are the business aspects of the worker’s job controlled by the payer? These include how the worker is paid, whether expenses are reimbursed, and who provides tools/supplies.

Type of Relationship: Are there written contracts or employee-type benefits such as a pension plan, insurance, sick pay, and vacation pay? Will the relationship continue indefinitely? Is the work performed a key aspect of the business?

Let’s look at an example involving Jim, John, and Joan. All three perform work for the ABC Repair Shop.

  • Jim works at the front desk, earns $10 per hour, works from 9am to 5pm, and takes complete direction for all of his duties from his supervisor.
  • John is a mechanic, earns $15 per hour, takes some direction from his supervisor, but only works on an “on call” basis when needed, using the company’s tools.
  • Joan is a master mechanic, paid depending on the complexity of the job, “generally” works from 9am to 5pm, but decides which autos to work on, uses her own tools, and takes very little direction from her supervisor.

Who is an independent contractor and who is an employee? Based on the information above, the answer is – it depends.

  • Jim: It’s likely that Jim is an employee as he takes all direction from his supervisor.
  • John: John could be an employee as he uses the company’s tools, but working on an on-call basis and only taking some direction from his supervisor makes his designation as an employee less certain.
  • Joan: Joan is likely an independent contractor as her rate is not fixed, she uses her own tools, and takes very little direction from her supervisor.

Keep in mind that any change in Jim’s, John’s or Joan’s duties or relationships with ABC could alter their status. According to the U.S. Department of Labor (DOL), misclassification of employees as independent contractors presents one of the most serious problems facing affected workers, employers, and the entire economy.

If the DOL finds that a worker has been misclassified and denied access to critical benefits and protections to which they are entitled, such as the minimum wage, overtime compensation, family and medical leave, and unemployment insurance – they can enforce employers to pay, not only going forward, but retroactively as well.

Case in point? Federal Express (FedEx) settled a long-running class action lawsuit with over 2,000 of its drivers. The reason? The DOL found that FedEx misclassified employees as independent contractors. The result? FedEx must create a $228 million fund to cover the claims.

The moral of this story is that employees and contractors aren’t black and white, and you should heed slipping into the ambiguous gray space where you might be breaking an IRS or DOL rule.

Here’s where having a valuable employment or business lawyer becomes a great resource. Your investment with a trusted lawyer as a partner can not only give you peace of mind that you’re doing everything by the book — but could also save you money down the road thanks to avoiding easy misclassifications or disputes. If you’ve already found yourself in a pickle with the law, let’s chat about your correction options.

Before you hire a contractor

If you do decide an independent contractor is the best option for you — here’s how to prepare with contractor law in mind. While this list is not exhaustive, it will provide you with some important background information before you hire a contractor.

  1. Understand the factors relevant to a worker being legally classified as an independent contractor.

Often, independent contractors are business owners who are in a profession or trade that offers services to the public. According to the IRS, a worker is an independent contractor for a business if the business owner can only control or dictate the type of work or result of the work to be completed and not the manner in which the work is completed.

A few questions can help you determine whether the person you want to hire is likely to be classified as an independent contractor rather than an employee. First, will you be hiring this person for a temporary project or projects? Second, will the worker determine where and when to conduct the work that will be done for you? Third, will this person use his or her own technology or equipment to complete the work? Finally, will the worker be paid on a flat-fee basis or hourly?

Generally, the more control the worker has over the manner in which the work is performed, the more likely the worker is to be classified as an independent contractor. The more the employer dictates the time, place, and manner in which the work is done, the more likely the worker will be legally classified as an employee. It is very important to make sure you classify your workers correctly as independent contractors or employees. You risk paying significant fines and penalties if you misclassify your workers.

  1. Verify credentials.

As with any new hire, make sure to request and review the prospective worker’s resume and references before the worker begins work. Review the worker’s resume, ask questions, and make sure the person has the qualifications and experience necessary to complete projects for your business. Also, call the references. If the worker owns a business, check the Better Business Bureau as well as online reviews. Make sure there are no complaints filed against the worker or any allegations that would make hiring the worker inadvisable.

In some instances, it may be appropriate to conduct background checks. However, you should do this primarily when a person’s criminal history is relevant to the work at hand. Ban the Box legislation is aimed at preventing discrimination in hiring of people with arrest records or convictions. However, some states require individuals working with children and the elderly to undergo a background check.

  1. Establish an accurate payment system.

Business owners should ask the independent contractor to submit detailed invoices for work performed. A contractor should not be paid prior to receipt and review of an invoice. Paying a contractor without receiving an invoice resembles payment of wages to an employee. In addition, a business owner should not withhold any taxes from the contractor’s payment. The contractor is responsible for paying the contractor’s income taxes, as well as Social Security and Medicare taxes. You will need to keep track of payments made to the contractor and report them to the IRS.

In addition to taking the steps outlined above, ensure that you have the following essential documents in place:

Tax forms: The independent contractor will complete a Form W-9 with the contractor’s Tax Identification Number, and you will complete the corresponding Form 1099-NEC to report payments made to the contractor to the IRS. Check with your CPA to ensure that you have complied with the state and federal requirements.

Independent contractor agreements: Every employee should sign an employment agreement with your business. Similarly, every independent contractor should sign a contract that defines the work to be performed, the nature of the relationship (independent contractor, not employee), termination provisions, and payment terms.

Confidentiality agreement: Your business’s success stems from its unique business strategies and trade secrets. When an independent contractor begins working with you, the contractor may become familiar with these strategies and secrets. Before the contractor begins any work for your business, you should ensure that the contractor has signed a nondisclosure agreement prohibiting disclosure of this confidential information to your competitors or anyone else without your permission.

Agreement not to compete or solicit:
Before a contractor begins work, you may also want the contractor to sign an agreement not to compete with you after the working relationship ends. A noncompetition agreement sets out terms to prohibit the contractor from competing with you in a certain geographic area and for a specified time after the relationship with your business has ended. Likewise, an agreement not to solicit is designed to prevent the contractor from taking your customers or employees with him or her when the contractor leaves. The contractor should sign a nonsolicitation agreement prior to beginning work.

Keep all records and agreements on file for each of your independent contractors. While you may not be required to turn over your files, if the IRS audits your business, having these documents will help confirm the nature of the independent contractor’s relationship with your business. Whether you’re looking for an employment lawyer or a business lawyer to walk you through the process, Schmit Law Firm is ready to help you reach your goals.

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