Winning the Independent Contractor Argument
Your business is growing. That’s great news! And, it could be a huge problem, all wrapped into one.
You will need to start thinking about adding people to your business. The need to hire and manage people is one of the top ten reasons people give for never wanting to have a business. Having employees can be painful and expensive.
As soon as you hire your first employee, you’re going to have to face a unique set of challenges. First, you need to find the right person. They have to match what you want for your business and be good workers. But as soon as you sign them on to the payroll, even if you start with a probationary period, you’re on the hook for payroll taxes and possibly even benefits. You’ll have to provide training and equipment. You have additional administration support needed so you can pay them with a legitimate payroll – payroll taxes and monthly, quarterly and annual reporting to your state, IRS and Social Security Administration.
And you need to foot the bill for all of this whether or not your business has a good month or a bad month and whether or not the employee helps or hurts your business.
Employees are expensive. It takes a while for them to get up to speed, and if there is a business change, they are expensive to lay off. Most small business owners hang on to employees way past the time they should.
What else can you do? There really are only a couple of other alternatives. You could stay small. You could continue to do all the work. Or, you could hire Independent Contractors (ICs).
Of these options, and as a CPA and business owner myself for over 30 years I think you should hire ICs.
If you stay small, you’re going to deny the power of your dream. If you try to do it all yourself, you could very well be working just to get exhausted, have a heart attack and lose your family. And, of course, you could hire employees. In some cases, that’s your only alternative.
There are seven reasons why you may want to use Independent Contractors.
Seven Reasons to Use Independent Contractors
Before you jump into deciding all of your workers should be employees or they should all be ICs, it’s important to weigh the differences. It’s difficult to change an employee into an IC and if you decide one class is ICs, then later make an exception for a person, you could blow all of your arguments. Let’s start with the seven reasons why ICs might be better for your business.
Reason #1: It’s Easier to Ramp Up Your Business
You can contract with Independent Contractors (ICs) for short terms, month-to-month or just on a per-project basis. You don’t have to worry about training them or providing tools for them to work. And, you should be able to get instant performance without a training curve.
The rule of thumb in a CPA firm is that it will take up to 6 months to get the cost of an employee at a break even point. Until then, an employee is costing you money. That’s why I only work with independent contractors who already have the training, education and expertise.
What about your business? How much will it cost you before an employee truly makes you money? Would an IC who can hit the ground running and who provides all their own training and tools be a better fit?
Reason #2: It’s Easier to Deal with Changes
The only certainty in business is change. If a project changes, you may need to change the number and/or type of works you have. It’s much easier to cancel an Independent Contractor Agreement (ICA) than it is to let an employee go. There are fewer emotional issues and you don’t have legal or benefit costs like COBRA to consider.
Reason #3: Quality Improves with an Independent Contractor
An IC who works for you will have a different mindset than an employee. He has his own business too, which means his reputation is on the line when he works with your company. He’s not watching the clock and putting in minimum effort to collect a paycheck.
Now granted, there are plenty of clearly dedicated people in the workforce who work as employees. Your business may already have some of these wonderful employees working for you. I hope someday they get the chance to use that dedication, hard work ethic and brainpower in building their own business instead of just yours. Being an IC is actually a good deal for both the business owner and the IC.
Reason #4: Independent Contractors are Value Focused, Employees are Time Focused
Employees are paid by the hour, the week or the month. They are not paid for a result. You simply can’t pay employees the way you can pay an Independent Contractor. I think philosophically that’s one of the biggest problems most businesses face. Governmental rules and regulations say you have to pay employees by “time.” If they put in the time, regardless of the results, they get paid. But if you switch to Independent Contractors, you can pay based on a result. In other words, when a project completes, or at various milestones, or as a commission for a result, you pay your IC.
In my tax consulting business I have Independent Contractors who are paid for preparing tax returns. If they don’t get the tax return done, they don’t get paid. It doesn’t cost me a dime if they don’t work, well, other than an irate client, I guess. On the other hand, if I had employees working on tax returns, I’d have to pay them by the month regardless of how many returns they completed. It’s a guessing game: Who can you hire that will work hard, no matter what?
Reason #5: Lower Hidden Support Costs
When you hire ICs, you can eliminate a big hidden cost. Let’s say you have a business that requires someone to work on the computer during the day. If you have an employee, you are paying them for their time, plus furnishing them with a place to sit, and equipment to do their job. So you’ll have additional overhead for office space, office furniture, phone/computer/equipment costs, tech support and so on. I estimate the hidden cost of an average office employee position to be about $10,400 in the first year, plus payroll taxes and benefits.
If you hire an IC, they are responsible for all of that.
Reason #6: Better Benefits for the Owners
As your business grows and becomes more prosperous, chances are you’re going to be even more focused on looking for benefits that you can receive from the company, tax free. But in an employer/employee environment, all employees have to be treated equally. So if you put in a MERP (medical expense reimbursement plan) or a retirement account partially funded by your business, you’ve got to offer that same benefit package to your employees, as well. If you have many other employees, you’ve just picked up a huge liability. ICs do not need to be covered by benefit plans. That’s a big cost savings.
Reason #7: Less Tax
Your biggest savings with Independent Contractors will probably be payroll taxes. Payroll taxes can cost you an additional 10% or more of the salary you pay your employees. Plus, your employee is going to have to pay payroll tax as well. By switching to an Independent Contractor relationships you can save yourself the payroll tax and show your new ICs how to minimize their own payroll taxes, income taxes, business taxes, and more.
Make no mistake: A properly set-up IC arrangement will mean less tax for both of you.
A Warning About the Independent Contractor Status
The IRS is ramping up audits of Independent Contractors. That includes both the people who hire the Independent Contractors and the people who file as Independent Contractors. Be prepared for more audit scrutiny if you use Independent Contractors.
And if you hire an IC in California, even if you don’t live there, beware. The California Department of Labor has recently ruled that most workers are employees, even if they pass the IC test for the IRS. My strong suggestion is that make any worker you have in California, an employee. This could mean that you also have to pay California income tax. Talk to a CPA who is knowledgeable about state nexus issues.
Outsourced Independent Contractors
If you hire ICs outside the country, they will not be treated as employees. So, if your business hires virtual assistants, programmers, designers, software engineers and the like from countries outside the US, you do not need to worry about the IC designation.
You Can Always Ask the IRS (Form SS-8)
You can always ask the IRS whether your workers are employees or independent contractors. You do that with a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
The IRS can take up to six months to get back to you with the answer. If you don’t like the answer you get, you’re pretty much stuck with it both for the workers under question and anyone else who fulfills the same position.
What if the IRS Determines Your Independent Contractor is an Employee
If you classify an employee as an independent contractor and the IRS determines you have no reasonable basis for doing so, you’ll be looking at employment taxes, penalties and interest. The penalties have gone up, so beware of this one! If you have an IC, make sure you’re treating them like an IC.
Relief Provisions
If you have a reasonable basis for treating a worker as an Independent Contractor, even if the IRS disagrees, you may not have to pay employment taxes.
To get this relief, you must file all required federal information returns on a basis consistent with your treatment of the worker. You (or any predecessor owner of the company) must have always treated that worker as an Independent Contractor since 1977.
While this may work to remove IRS penalties, you may still be subject to state and local taxes. Again, beware of California.
The Ultimate Revenge for a Disgruntled IC
Besides an aggressive IRS audit force, you also have to worry about the Independent Contractors themselves. The IRS has made it easy for workers to turn you and your company in if payroll taxes haven’t been collected. That’s another good reason to make sure you have a solid Independent Contractor Agreement.
Workers who believe they have been improperly classified as independent contractors by an employer can use Form 8919, Uncollected Social Security and Medicare Tax on Wages to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation.
Test #1: IRS Challenge of Independent Contractors
What happens if the IRS challenges the IC status of your workers?
First, they are going to perform a test known as the Internal Revenue Code (IRC) Section 530 Test. If you can qualify first under IRC Section 530, you’re done. You have ICs. If you can’t do that, then you go to Common Law Rules,which we’ll review after this module.
Under IRC Section 530, the IRS is bound by the taxpayer's classification of IC versus employee, provided the taxpayer:
(1)Filed all necessary tax and information returns. If you have Independent Contractors you MUST provide a Form 1099. (The exception would be if your IC operates through a corporation and you pay the corporation, rather than the individual). Make sure you get a Form W-9 for the IC right away. You can download the Form W-9 from the IRS’s website,
(2)Consistently treated the worker as an independent contractor. Remember the differences between an IC and an employee. An IC is responsible for his or her own taxes, including worker’s compensation. An IC is responsible for how and when they perform the contracted work. To protect yourself here, make sure you get a written agreement with your IC, and, better yet, insist that your ICs all operate through their own business structures. This won’t insure you have an IC arrangement, but it will be a problem if you don’t have such an agreement.
If your current worker is an employee, don’t try to make them an IC. This would go against the ‘consistently treated’ argument. Also, if you have hired people in this current position as employees, don’t try to change it now.
(3)Had "any reasonable basis" in determining that the worker was an independent contractor. The " reasonable basis" standard may be satisfied by meeting any of three statutory "safe havens:" (i) judicial precedent and published IRS rulings, whether or not they relate to the particular industry or business in which the taxpayer is engaged; (ii) a past IRS audit of the taxpayer where no assessment was made regarding employment taxes of workers holding positions substantially similar to the position held by the worker whose status is at issue; and (iii) a long-standing recognized practice of a significant segment of the industry in which the worker was engaged -- although the practice need not be uniform throughout the entire industry.
This will be the hardest one to prove. But if you’ve had a case before or someone in your industry has and been able to maintain the IC relationship, you’re more likely to win.
How to Prove a True Independent Contractor Relationship
The next test, and the one you’re almost certainly going to need to face, is the Common Law Rule Test. This test is comprised of three main areas:
- Behavioral Control
- Financial Control
- Type of Relationship
Behavioral Control
Does your business have the right to direct and control how the worker does the task for which they are hired? What is the level of instruction that you give the worker?
The more defined these instructions are, the more likely the worker is an employee. For example, if you control your contractors in any of the following ways, the IRS will likely claim you have an employee:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or assist with work
- Where to purchase supplies and services
- What work must be performed by a specified individual
- What order or sequence to follow
The key is whether or not you’ve retained the right to control the details of a worker's performance. Try to stick to simply contracting for a desired goal at a certain deadline and let your IC’s do the rest.
Financial Control
Again, your goal here is to be hands-off. The IRS expects Independent Contractors to have things like unreimbursed expenses, and fixed costs that are independent of the contract. An IC who maintains a separate office is a great example of the independent contractor’s fixed cost. How about other clients? The more clients a IC has, the more likely the independent contractor relationship will be upheld.
The payment structure is also important here. Employees receive regular wages. The more irregular your payments to ICs are, the better. Try to pay on a per-job basis where possible, as opposed to regular installment or retainer payments. Another key factor is the profit/loss component. True ICs can make a profit or post a loss on a job.
Type of Relationship
Is there a written contract between your business and your ICs? This is a great way to set out the independent nature of your relationship (although it may not be enough all by itself). Be very careful not to provide anything that could be construed as an employment benefit. Do NOT provide any perks like insurance, pension benefits, vacation, sick pay, etc.
Make sure your contract has a fixed period. If you have an open-ended deal, that can work against you. That doesn’t mean you can’t renew the contract after each period has ended – you can. But it’s safer to stay away from contract language that says things like “automatically renews for additional terms.”
The Common Law Rule Test in Detail
The IRS may ask you specific questions regarding the IC relationship you have. These are questions direct from their Audit Technique Guide.
Behavioral Control
Behavioral controlrefers tofacts that show whether there is a right to direct or control how the worker does the work. A business has the right to direct and control how an employee works. But a business does not direct and control how an Independent Contractor works.
The questions under Behavioral Control fall under four categories:
- Type of instructions given
- Degree of instruction
- Evaluation systems
- Training
Types of Instructions Given
An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work. If you’re providing this type of detail, you’re more likely to have an employee then an Independent Contractor.