Independent Contractors

When someone performs services for a business, he may be deemed an employee or an independent contractor. The differences between the two are highly significant, as explained below.

The small business owner should use independent contractors, rather than employees, whenever possible. The use of independent contractors, rather than employees, is one of the most effective asset protection tools because the employer:

• is not liable for torts committed by an independent contractor he employs, as the doctrine of respondeat superior does not apply to independent contractors; this fact is in stark contrast to the law that applies to torts committed by employees, and makes the use of independent contractors a singularly effective tool in eliminating tort liability that otherwise would apply against the limited liability company (LLC) or corporation
• is not required to pay employment taxes (Social Security and Medicare tax as well as unemployment tax) or worker's compensation insurance on the wages paid to independent contractors and, similarly, is not required to withhold federal income taxes for the wages paid. The employer pays the independent contractor only his gross wages. At the end of the year for each independent contractor paid $600 or more, the employer must send the independent contractor and the IRS a Form 1099-MISC showing the gross wages paid

An additional benefit is that the law does not require that independent contractors participate in any retirement plan offered by the employer. In contrast, anti-discrimination rules usually mean all employees must be covered by an employer-sponsored retirement plan.

The employment tax savings alone warrant the use of independent contractors. When the employer uses employees, rather than independent contractors, the Social Security and Medicare taxes paid by the employer amount to 7.65 percent of wages paid. Federal and state unemployment taxes typically average 0.8 percent of wages. This, of course, is in addition to unemployment insurance, which can be quite costly in many businesses.

In addition, recordkeeping is simplified, because no withholding from wages or employer tax reports are necessary. As a result, the small business owner normally will not need a payroll service, which will produce still more savings.

Nevertheless, the tax savings pale in comparison to the elimination of the business's tort liability.

Independent contractors are self-employed. In essence, they are operating their own business (usually as sole proprietors). Accordingly, they report their wages on Schedule C of IRS Form 1040, pay their own Social Security and Medicare taxes (termed a self-employment tax), and file their own estimated taxes in quarterly reports. The self-employment tax, before any reductions, amounts to 13.3 percent for 2011, because of a temporary payroll tax deduction. (The rate will return to 15.3 in 2012.) Because of the steep self-employment tax and the additional recordkeeping that will be required, many workers will object to independent contractor status and insist on being deemed employees. Workers also may object to independent contractor status because they want to participate in the business's retirement plan.

A small business owner can choose to use independent contractors, but their ultimate classification as such is not up to the employer. Strict rules must be followed so workers are properly deemed as independent contractors. A good place to start is with a written employment agreement, which clearly labels the worker as an independent contractor.

However, labels will not control the outcome. The law (both tax law and agency law) has developed elaborate rules that control whether a particular worker is properly classified as an independent contractor. If the worker does not meet these tests, the label will mean nothing. The worker will be re-classified by the courts or the IRS as an employee. If this happens, the small business owner can expect a bill for back employment taxes, with interest and a 100% penalty, or an unfavorable outcome in a tort lawsuit.

Be very careful about mislabeling workers. Because of the significant payroll tax advantages to using independent contractors, the IRS targets misclassifications when it audits small businesses. Another instance when a misclassification may come to light is when a worker commits a tort and the injured party seeks to sue the LLC or corporation under the doctrine of respondeat superior. Here, the misclassification is at least worth a try. If the suit is lost, the result is no worse than if the worker had been properly classified in the first place. Overall, however, the risks associated with an IRS audit may outweigh the benefits realized here.

Independent contractor legal guidelines. There is a 20 factor test that is used to determine whether workers are properly classified as independent contractors or employees. Many of these factors can be condensed into one factor--control. What follows is a comparison of the two forms of employment, in terms of this factor.

Who Controls Them?
Independent Contractors	Control themselves. They determine their own fees and their own working hours, and provide their own tools. Fee usually set as bid per job. Usually work for multiple employers. Leave one employer when the job there is finished.
Employees	Controlled by the employer. The employer determines the wages, paid (as an hourly wage or annual salary), and the working hours. The employer also provides all the tools of the trade. Usually work for one employer on a more or less permanent basis.

Unfortunately, cases will usually turn on the peculiar facts of each particular employment situation.

The following three examples were taken from actual tax court cases: Bicycle assembly workers were deemed employees even though they brought their own tools to work, furnished their own transportation to sites, and were largely unsupervised at sites because the employer had absolute control over the workers in terms of directing their rate of pay, working hours, assignments, etc., and prohibiting them from working for competitors. Telephone company solicitors who worked on the premises of the telephone company were deemed employees, but solicitors who worked at home were deemed independent contractors because they provided their own "tools of the trade." Associate physicians at a hospital were deemed employees because the hospital could fire them if they did not meet hospital standards, thus indicating that the hospital had control over the physicians.

Be sure to check all 20 factors in the IRS test before attempting to use independent contractors. If there's any doubt, consult a legal professional.

IRS Section 530 Independent Contractor Safe Harbor Rule. There is a safe harbor for employers interested in using independent contractors for tax purposes. Note that this safe harbor will apply only in tax cases and should have no bearing in a tort case where the plaintiff is seeking to hold the employer accountable under respondeat superior. Further, under the safe harbor rule, employers remain liable to contribute to retirement plans, and are still required to withhold income tax and Social Security tax from employees' wages.

The small business owner should attempt to fit his use of independent contractors into the confines of the IRS Section 530 safe harbor. To do so, the employer must prove two things, that the owner: did not, ever, classify this worker, or any similar workers, as employees had a reasonable basis for classifying the worker as an independent contractor, either because of the common law tests or because a significant segment of the industry (usually 20 percent, but perhaps as low as 18 percent) has treated workers of this type as independent contractors for a long period of time (generally, at least 10 years). Section 530 is not available when the worker provides services as an engineer, designer, drafter, computer programmer, systems analyst or any similar line of work.

Under the Section 530 safe harbor, a showing any reasonable grounds were relied on in classifying the worker shifts the burden from the employer to the IRS to disprove independent contractor status. Unless the IRS can do this, the classification is presumed to be valid. This provides the advantage of a low burden of proof for employers.

Temporary employees. In many cases, temporary workers are considered employees of the temp agencies that hire them. However, for tax purposes, workers may have two employers and be considered employees of both the temp agency and the company to which they are assigned. In short, with respect to temp agency workers, the regular 20-factor test or the Section 530 safe harbor rules will apply.

Independent Contractor Exceptions. In tort cases, contrary to the general rule, courts may hold an employer liable for the acts of his independent contractor when:

• the employer has a legal duty that may not be delegated to another (such as the duty of an apartment building owner to maintain the premises in a safe condition)
• the activities involved are abnormally dangerous (such as using dynamite)
• the employer was negligent in hiring the independent contractor and, thus, committed a separate tort

Further, in contrast to the safe harbor rules, the IRS has special exceptions that govern independent contractor status for certain workers. These workers are automatically, for tax purposes only, deemed to be statutory employees.

These rules include an employer's workers who are:

• independent drivers who deliver beverages (other than milk), meats, vegetables, fruits, bakery products, or laundry or dry cleaning
• sales workers who call on hotels and restaurants
• home workers who perform work in their own home or the homes of others and are paid more than $100 during the year
• full-time life insurance salespersons

The employer, in each case, must withhold and match the required Social Security and Medicare taxes, as would be done for any other employee, but is not required to withhold income taxes from the employee's wages. Finally, except for full-time life insurance salespersons, statutory employees like independent contractors may be excluded from employee retirement plans.