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Contractors must really be independent!

How many of us have “hired” independent contractors over the years, a bit worried over the gray area between employee and contractor as defined by the IRS?  I’ve experienced the results of a wrong decision, and the IRS and state agencies are not forgiving in their pursuit of penalties, interest and most damaging, assessing a company with the on both employer and employee taxes when reclassifying the person as an employee.

Yes, that’s right. The company must pay the employee’s portion of the taxes (and penalties on these) as well as paying those they would have paid if the person were an employee.

And the IRS has raised the bar on its test as to whether an independent contractor is not in reality an employee.   So it is important – no really urgent – that we review some of the twenty – yes twenty – tests the IRS now uses to determine if a person is an independent contractor.

1. Contract for service:  An independent contractor should work under a written contract with the company, defining the end result expected, time to achieve, lump sum or unit cost, ownership of intellectual property created and more.

[Email readers, continue here…]  2. Direction: The contractor directs itself, rather than being managed as an employee.   And just as important, a contractor does not supervise any of the company’s employees directly.  This is tricky when a contracted CFO assumes a position of directing an accounting department.  Usually, in acceptable cases such as this, the contracted executive comes from a recognized agency with a history of paying its own employee taxes, health insurance, and other benefits.   Without this protection, a contracted executive is suspect, even if working with more than one company at a time.

Three_Berkonomics_Fronts_black3. Integration: A contractor provides services which are not an integral part of the core business of the employer.  This one is tricky.  Is a contracted CFO an employee because the CFO job is integral?   How about a contractor CEO?   The person must pass all the other tests when one of them, such as this, crossed into the very gray zone.

4. Individual on the job: A contractor may hire a substitute without the company’s permission – although the company should then be able to terminate the contract with the contractor if the substitute is not acceptable.

5. Term:  A contractor is hired for a specific project, usually tied to a time term. An undefined period of time favors the ruling as employee.

6. Reporting: Here is a surprise. The IRS wants to test that a contractor is NOT required to submit regular reports.  Yet, most of us would want to have such documentation of progress other than an invoice.

7. Tools and materials: The contractor must supply his or her own tools.  This is tricky when a contractor sits at your desk using your computer and your phone system all day.

8. Physical facility: The contractor must have its own “home office” even if in a bedroom, from which primary work is performed.

9. Works for more than one company:  If such a person works only for a single company for any period of time, that person will probably be determined to be an employee.  A contractor must make services available to the general public.

10. Termination: A contractor works under a contract – which means that an independent contractor cannot be “fired,” as long as results are satisfactory as defined within the contract of service.

There are more tests, but these are the ones most often used by the IRS.  States add a few of their own; so beware.   Pay contractors using account payable systems, not payroll services.  Pay only upon receipt of invoices, not with regularly triggered checks or transfers of uniform amounts without invoice documents to back up the payments.

Many small or early stage company CEOs look for opportunities to cut cash drains, knowing that payroll is usually the greatest cash drain of all. The temptation to reduce that by fourteen percent or more by classifying a gray area employee as a contractor is very high.  And that includes self-payments to a founder.

Founders working for a company are employees if they take regular payments, subscribe to company benefits, attend regular company meetings, or fail any of the tests above.  The temptation to just draw cash and call it a loan, or document a year’s withdrawals with a 1099 is great, but highly risky.

There is nothing worse than a large tax bill and threats of a government agency seizing a cash account when a company cannot or does not respond with proper documentation or payment.  And even a single year’s worth of transgressions, when added into a single tax bill with penalties and interest, can appear daunting to small and young companies.

Like payment of payroll taxes by incremental impound each pay period, as opposed to waiting until the last minute and making manual tax payments, it is a proper discipline of management to “take the hit” incrementally to protect the business from a catastrophic failure to pay a governmental agency any form of tax when and as due.   Need we emphasize the personal liability of management AND the board of directors attached to tax payments?

Good management takes discipline and enough knowledge to prevent these possibly crippling errors in judgment that stem from decisions made to avoid or put off tax payments when accrued or due.

  • It’s good to know that the contractor should bring their own tools and supplies. My spouse and I are thinking about renovating our home this year to make it more modern. We need to find a local contractor that has a lot of experience with what we’re trying to do.

  • I love that you talked about working with a contractor that is under a written agreement. My uncle is going to do some renovations in his office so that it looks more modern. He needs to find a local contractor that is willing to work closely with him until this project is done.

  • It’s good to learn that an independent contractor must supply their own tools for work. My brother is interested in working as an independent contractor. I’ll be sure to tell him that he’ll need to supply his own tools for the jobs he works.

  • It’s interesting that you talked about how independent contractors should work under written contracts with the company. My son wants to hire a contractor to help him with the construction of a new office this fall and we’re trying to find all the information we can about the process. We will remember this information while moving forward with the construction process.

  • F Mann

    Contractors pay FICA and Medicare directly to the IRS anyway. Do they get more $$ when it comes from the company?

    Is the issue the 1/2 of FICA I can deduct on my 1040 which lowers my personal tax bill?

    • The IRS is concerned because companies save by not paying the FICA, FUTA or Medicare taxes for contractors. Yes, upon receiving a 1099, contractors should report the earnings and pay both the employee and employer taxes, making the IRS almost whole (FUTA not included) – but many contractors never report. Since companies must withhold income tax as well, those contractors who never report never pay any of the taxes. So the IRS focuses upon the companies issuing the cash, and penalizes them with a stiff stick – 25% penalty, interest, and a forced payment of both the employee and employer taxes. Since the contractor who should have been an employee would have paid only 1/2 of the taxes if classed as an employee, this penalty is doubly hurtful upon the employer who misclassified the errant employee as a contractor to avoid “some” tax. Over time, this gets to be a very large amount indeed. And no-one wants to receive a notice from the IRS, which has the power to pierce the corporate veil and go after owners AND members of the Board of Directors of a company.

  • Mike Stuhley

    Good article. An issue almost everyone has to deal with.

  • Excellent advice!

    I’ve been on both sides of this issue. In addition, my partner has an M.S.T. (that’s taxation). Small business owners tend to seek many ways to save on IRS taxes.

    If you run a business from your home, how does the IRS know how your phone bill should be split? We have a single phone on a separate bill that’s designated as personal. Our phone lines come directly from Verizon, and a business cell phone does to — set up so that all of these appear on one bill.

    While the new rules are different, when I was doing independent contracting, I was careful to obey these rules. Sometimes, I ran projects for clients and had their employees doing work on them. However, I never did or even participated in performance or salary reviews. I reviewed the work, not the person.

    I recently completed the Goldman-Sachs 10,000 Small Businesses program, and a few hours were devoted to this very issue because it’s so important and no misunderstood. It’s also very easy to avoid breaking the rules if you know them. It’s not worth avoiding those FICA and Medicare fees if the person is actually an employee.

    We currently have sales contractors and take great care with the rules.

    Let me finish with this thought. You never want any trouble with the IRS. They have powers not available to other government agencies.

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