Beware costly tax penalties when using independent contractors

Although the use of independent contractors is a popular way of controlling expenses, employers need to be aware of the downside: Back taxes and costly penalties can result if the Internal Revenue Service (IRS) reclassifies self-employed workers as employees. “This topic causes the most panic in the human resources area,” says Dr. Edward H. Hernandez, associate professor of management at California State University in Stockton, Calif. “Many business operators are not knowledgeable about the law.”

The risk of running into a problem is high because the IRS has not provided a clear-cut definition of what constitutes an independent contractor. “Businesses are often shocked to learn that people who perform services for them are their employees in the eyes of the IRS and state departments of unemployment insurance, unless business owners can prove that these people are under contract,” says Nancy E. Joerg, an employment attorney with the law firm of Wessels & Pautsch in St. Charles, Ill.

Employers find themselves under fire from several fronts. One audit by the federal or state government usually triggers action by the other. And the wage and price division of the U.S. Department of Labor also gets involved, often determining that an employer failed to pay overtime for those reclassified individuals who worked more than 40 hours a week. That means still more retroactive taxes and fines.

Major problems often arise when a departed worker blows the whistle on questionable practices. “People who report wrong classifications can get up to 33% of what is recovered,” Hernandez says. “Because of the big financial incentive, almost invariably someone will whistleblow.”

The attractions of independent contractors are obvious. They can be used on a regular basis for tasks that require skills not already found inside the business or for temporary periods to ease heavy workloads or accomplish specific projects without bloating the payroll. They often perform such duties as sales, bookkeeping, support services, caregiving, dictation, secretarial work, delivery of materials, research, chauffeuring executives back and forth, janitorial services, and a host of other activities.

No wonder employers are seeking self-employed people more often. “The use of independent contractors is increasing very rapidly,” says Joerg. “It's very costly to have a regular employee workforce, which is a fixed item of overhead. It's more financially advantageous to add to and subtract from an organization's workforce as the need changes. It's much easier to do that than to fire and hire all the time.”

“The IRS is making this a top priority for litigation purposes,” warns Allen L. Schwait, a Baltimore attorney who has defended businesses in such cases, “so people need to learn the law.” The time to act is now. For each of your independent contractors, answer the 20 questions below. Attorneys have culled these questions from court cases and IRS decisions during the past few years. The more you answer “yes” to these questions, the more likely the IRS will decide your outside contractors are really employees.

Caution: These questions are only general guides. There is no cut and dried method to determine independent contractor status. Consult your attorney for detailed advice about your outside contractors.

1. Must the worker follow your instructions as to how work is to be performed? This question is listed first because in some ways it is the most important. It cuts to a fundamental element of IRS reasoning that appears in many of the other questions that follow: the more control you have over the activity of your worker, the more likely it is that you have a full-time employee on your hands.

“The overriding issue has always been control,” says Schwait. “Do you tell the person when to come and go? Or do you direct the way the person does the job on a regular basis? If so, the person may be deemed to be an employee.” Schwait further notes that this guideline can apply if you only have the right to make such directives, even if you do not actually do so.

Compare this with a situation in which you simply say to the worker: Give me a price and do the job. “That person is more likely an independent contractor,” says Schwait.

2. Do you train the individual? If you train the individual to perform job duties, this can indicate you have control over the person. Once again, the presence of control implies an employment situation to the IRS. Such training can take the form of counseling, requiring the individual to attend meetings, or having the person work with a coworker who explains job duties.

3. Are the worker's services critical to the continuation of your business? If the progression of your business depends on the results of the worker's labors, it follows that your business will be more likely to attempt to control such labors. The IRS says this arrangement implies the person is an employee.

4. Do you require the individual to perform the work personally? Insistence that the worker perform the labor personally implies a measure of control over how the work is performed and that the worker is an employee. A true independent contractor, goes the reasoning, could assign the work to someone else.

5. Do you hire assistants for the individual? Your role in hiring assistants for your worker implies control over such assistants and an employment status for the individual. In contrast, an independent contractor would be likely to hire and fire assistants without your intervention.

6. Do you have a continuing relationship with the individual? Even if work is performed at irregular intervals, the fact that you use the individual's services over a long period is one factor that tends to indicate an employment status.

7. Do you dictate what hours the individual works? Suppose you insist that the individual show up for work at a certain time, or suppose you state that the person must work a set number of hours each day. This exerts control over an employee.

8. Do you require that the individual spend all of the working day on your projects? If you insist that the individual devote full time to your projects, the IRS has deemed that a form of control over an individual. This situation keeps the worker from doing other gainful work. In contrast, an independent contractor would be free to work for other businesses.

9. Does the individual work on your premises? Workers who perform duties on your premises implies you exert some control over them. The IRS puts particular emphasis on this factor if the work could be done just as well at another location. “I often suggest that an employer include a rental provision in the contract and have the independent contractor pay rent,” says Joerg, adding that such a clause has proven itself helpful in some of her court victories at both state and federal level. “It's one way to turn a negative into a positive: What employee, after all, pays for the space used when working?”

10. Do you dictate that work be done in a certain sequence? Suppose you order that specific steps required for a project be done in a certain order. The IRS has determined that this implies a measure of control over the worker and suggests an employment situation.

11. Do you require reports of steps taken or work accomplished? The IRS says telling the worker that oral or written reports must be submitted suggests a degree of control.

12. Do you pay by the hour, week, or month? Periodic payments can indicate an employment situation to the IRS. The exception is if such payments are simply installments in a lump sum agreement for a project fee, a typical arrangement in an independent contractor relationship. In contrast, payments by project or commission payments generally lean toward independent contractor status.

13. Do you pay the individual's business or travel expenses? Reimbursement of a worker for business and travel expenses may imply a degree of control over his activities. The IRS thinks the party who ultimately pays the expenses will have some say over a ceiling of expenses for each category of expense, and thus over the worker's activities.

14. Do you furnish the worker's supplies or equipment? If the worker uses your materials on the job, this implies an employer/employee relationship. A true independent contractor would possess a set of equipment for performing similar tasks for other businesses.

15. Does the worker depend on your investment in workplace areas to get the job done? If the worker uses facilities that you have developed to perform duties, an employer/employee relationship is implied. In contrast, a worker who has invested significant money in an office implies independent contractor status.

16. Does the worker have no risk of loss from the results of the services rendered? If a worker does not incur the risk of loss normally associated with running an independent business, an employment relationship may exist. An independent contractor can realize a profit or loss from businesses in which that individual is engaged.

17. Does the individual work only for your business? A worker who is engaged only by your business may well be an employee. In contrast, a worker who performs duties for many clients is more likely an independent contractor.

18. Does the individual fail to offer services to the general public? A worker who does not promote services to the general public may be deemed an employee of your business. In contrast, an independent contractor does autonomous business.

19. Do you have the right to fire an individual? If you hold the threat of dismissal over a worker if instructions are not followed, the IRS may decide you are an employer. Compare this situation with an independent contractor's, who cannot be dismissed as long as the work accomplished meets the specifications outlined in a contract.

20. May the worker quit at any time without incurring a loss? The individual who may cease working for you and not assume a liability for doing so is often seen to be an employee. On the other hand, an independent contractor who quits on you incurs liability for breaking a contract and may be subject to a lawsuit.