Your Legal and Tax Guide to Hiring and Working with Independent Contractors

1. Benefits and Risks of Working With Independent Contractors

• Benefits of Using Independent Contractors
• Risks of Using Independent Contractors

2. Tests for Workers’ Status

• When a Legal Test Is Necessary to Determine a Worker’s Status
• The Common Law Test
• Factors for Measuring Control of Your Workers
• Evaluating a Worker’s Status Under the Common Law Test
• Economic Realities Test
• ABC Test

3. How the IRS Classifies Workers

• Four Steps to Classification Under the IRS Rules
• Step One: Check Statutory Independent Contractor Rules
• Step Two: Analyze the Worker Under the Common Law Test
• Step Three: Check Statutory Employee Rules
• Step Four: Check the Safe Harbor Rules

4. IRS Audits

• Why Audits Occur
• Audit Basics
• The Classification Settlement Program (CSP)
• Voluntary Classification Settlement Program (VCSP)
• IRS Assessments for Worker Misclassification
• Penalties for Worker Misclassification
• Interest Assessments
• Criminal Sanctions
• ACA Penalties
• Retirement Plan Audits
• Worker Lawsuits for Pensions and Other Benefits

5. State Payroll Taxes

• State Unemployment Compensation
• State UC Classification Tests
• State Disability Insurance
• State Income Taxes
• California Worker Classification Rules (AB 5)

6. Workers’ Compensation

• Basics of the Workers’ Compensation System
• Who Must Be Covered
• Exclusions From Coverage
• Classifying Workers for Workers’ Compensation Purposes
• If Your Workers Are ICs
• Obtaining Coverage

7. Health, Safety, Labor, and Antidiscrimination Laws

• Affordable Care Act
• Federal Wage and Hour Laws
• Federal Labor Relations Laws
• Family and Medical Leave Act
• Fair Credit Reporting Act
• Antidiscrimination Laws
• Worker Safety Laws
• Immigration Laws

8. Intellectual Property Ownership

• What Is Intellectual Property?
• Laws Protecting Intellectual Property
• Copyright Ownership
• Trade Secret and Patent Ownership

9. Strategies for Avoiding Trouble

• Hiring Incorporated Independent Contractors
• Employee Leasing

10. Procedures for Working With Independent Contractors

• Before Hiring an IC
• While the IC Works for You
• After the IC’s Services End

11. Independent Contractor Agreements

• Using Written Agreements
• Drafting Agreements
• Essential Provisions
• Optional Provisions
• Sample IC Agreement

12. Finding Legal, Financial, and Other Help Beyond This Book

• Finding and Using a Lawyer
• Help From Other Experts
• Doing Your Own Legal Research

Appendix A: How to Use the Downloadable Forms on the Nolo Website

• Editing RTFs
• List of Forms Available on the Nolo Website

 Appendix B: Contractor Screening Documents

• Independent Contractor Questionnaire
• Worker Classification Checklist

Index

Chapter 1:
Benefits and Risks of Working With Independent Contractors

There are many benefits to hiring ICs, but there are serious risks as well. No book can tell you whether you should use ICs in your business, but this chapter will help you make an informed decision by summarizing the potential advantages and disadvantages.

Benefits of Using Independent Contractors

It can cost less to use ICs instead of employees because you don’t have to pay employment taxes and various other employee expenses for ICs. In addition, you will be less vulnerable to some kinds of lawsuits. Perhaps most importantly, hiring ICs gives you greater flexibility to expand and contract your workforce as needed.

Financial Savings

It usually costs more to hire employees than ICs because, in addition to employee salaries or other compensation, you will have to pay a number of employee expenses. On average, these expenses add 30% to your payroll costs. For example, if you pay an employee $20 per hour, you must pay an additional $6 per hour in employee expenses. You incur none of these expenses when you hire an IC.

In addition to the costs of payroll processing, the most common employee expenses include:

• federal payroll taxes
• unemployment compensation insurance
• workers’ compensation insurance
• office space and equipment, and
• employee benefits like paid vacation and health insurance.

Federal Payroll Taxes

Employers must withhold and pay federal payroll taxes for employees. They must pay a 7.65% Social Security and Medicare tax and a small—usually 0.6%—federal unemployment tax out of their own pockets. In addition, employers must withhold Social Security and Medicare taxes and federal income taxes from their employees’ paychecks, and periodically hand this money over to the IRS. (See Chapter 3.)

In contrast, you don’t have to withhold or pay any federal payroll taxes for ICs. This will help you save money, not only in taxes, but in book­keeping costs as well.

Unemployment Compensation

Employers in every state are required to contribute to a state unemployment insurance fund on behalf of most employees. The unemployment tax rate is usually somewhere between 2% and 5% of employee wages, up to a maximum amount set by state law. (See Chapter 5 for more on unemploy­ment compensation rules.)

Workers’ Compensation Insurance

Employers must provide workers’ compensation insurance coverage for most types of employees in order to provide some wage replacement and
reim­bursement of medical bills if an employee is injured on the job. Depending on the state, employers can get workers’ compensation insurance either from private insurers or state workers’ compensation funds. Premiums can range from a few hundred dollars per year to thousands, depending upon the employee’s occupation and the company’s claims history. Employers don’t have to carry workers’ compensation insurance for ICs. (See Chapter 6 for information about state workers’ compensation laws.)

Office Space and Equipment

Employers typically provide their employees with workspace and whatever equipment they need to do their jobs. This isn’t necessary for ICs, who ordinarily provide their own workplaces and equipment. Office space is usually an employer’s second biggest expense; only employee salaries and benefits cost more.

Health Care

The Affordable Care Act (“ACA,” also known as “Obamacare”) requires that all employers with the equivalent of more than 50 full-time employees provide them with minimally adequate health insurance or pay a penalty to the IRS. The ACA’s employer mandate does not apply to independent contractors—they don’t count toward the applicable employee threshold. Thus, using ICs can save a hiring firm substantial sums on health insur­ance. The ACA also encouraged many employees to leave their jobs and become independent contractors: It enabled them to obtain their own in­dividual health insurance coverage even if they had preexisting conditions. (See Chapter 7 for a detailed discussion of the ACA.)

Employee Benefits Other Than Health Care Insurance

Employers usually provide their employees with benefits such as paid vacation, sick leave, retirement benefits, and life or disability insurance. You need not—and should not—provide ICs with such benefits.

Reduced Exposure to Lawsuits

When you hire employees, you may be subject to some types of legal claims that ICs can’t make against you.

Labor and Antidiscrimination Laws

Employees have a wide array of rights under state and federal labor and antidiscrimination laws. Among other things, these laws:

• impose a minimum wage and require many employees to be paid time-and-a-half for overtime
• make it illegal for employers to discriminate against employees on the basis of race, religion, gender, national origin, age, or disability
• protect employees who wish to unionize, and
• make it unlawful for employers to knowingly hire illegal aliens.

In recent years, a growing number of employees have brought lawsuits against employers alleging violations of these laws. Some employers have had to pay hefty damages to their employees. In addition, various watchdog agencies, such as the U.S. Department of Labor (DOL) and the U.S. Equal Employment Opportunity Commission (EEOC), have authority to take administrative or court action against employers who violate these laws.

Few of these antidiscrimination and employment laws apply to ICs, so you have much less exposure to these kinds of employee claims and lawsuits when you use ICs instead of employees. (See Chapter 7.)

Wrongful Termination Liability

Employees can also sue for wrongful termination. In these legal actions, an employee claims that his or her firing was illegal or constituted a breach of contract. Wrongful termination laws vary from state to state. Under some circumstances, for example, it might be a breach of contract for you to fire an employee without good cause. To guard against wrongful termination claims, employers must carefully document the reasons for firing an employee so they can defend their actions in court, if necessary.

ICs cannot bring wrongful termination lawsuits. However, there usually are contractual restrictions on when you can fire an IC. For example, your contract might state that you can fire an IC only with written notice, or only for his or her failing to meet obligations under the contract. If you disregard these limits, you could face a breach-of-contract lawsuit.

Liability for Workers’ Actions

When you hire an employee, you’re liable for anything he or she does within the scope of employment. For example, if an employee gets into an auto accident while making a delivery for work, you may be liable for the damages.

Subject to several important exceptions, this is not the case with ICs. You are not liable for an IC’s actions, work-related or not, unless one of the following is true:

• The IC you hired was not qualified to do the job and you were negligent in hiring him or her.
• An injury occurs because of your improper instructions to the IC.
• You know the IC is violating the law in working for you—for example, you hire an unlicensed IC to perform work that requires a construction contractor license.
• You hire an IC to do work that is inherently dangerous—for example, building demolition.

Flexibility in Hiring

Working with ICs provides a level of flexibility that you just can’t get from employees. You can hire an IC to accomplish a specific task, which gives you specialized expertise for a short period. You need not go through the trauma and potential severance costs (and lawsuits) of having to lay off or fire an employee. And an experienced IC can usually be productive immediately, eliminating the time and expense of training. By using ICs, you can expand and contract your workforce as needed, quickly and inexpensively.

Risks of Using Independent Contractors

After reading about the possible benefits of using ICs, you might be thinking: “I’ll never hire an employee again; I’ll just use independent contractors.” But be aware that there are some substantial risks involved in classifying workers as ICs.

Federal Audits

The IRS wants to see as many workers as possible classified as employees, not ICs, so that it can immediately collect taxes based on payroll with­ holding. Also, the IRS believes that ICs are more likely to underreport their income when tax time rolls around.

If the IRS audits your business and determines that you have mis­classified employees as ICs, it may impose substantial interest and penalties. Such assessments can easily put a small company out of business. The owners of an unincorporated business may be held personally liable for such assessments and penalties. Even if your business is a corporation, you could still be held personally liable for the tax, interest, and penalties.

Other federal agencies can also audit businesses for misclassifying employees. These include the Department of Labor, which enforces the federal minimum wage and hours laws; the National Labor Relations Board, which enforces employees’ federal right to unionize; and the Occupational Safety and Health Administration, which enforces workplace safety laws. (See Chapter 7 for information about labor and antidiscrimination laws.)

Legal Implications of Employment Classification
Entity	Law	Areas Potentially Affected by Employee Misclassification
U.S. Department of Labor	Fair Labor Standards Act	Minimum wage, overtime, and child labor provisions
	Family and Medical Leave Act	Job-protected and unpaid leave
	Occupational Safety and Health Act	Safety and health protections
U.S. Department of the Treasury— Internal Revenue Service	Federal tax law, including: Federal Insurance Contributions Act, Federal Unemployment Tax Act, Self-Employment Contributions Act	Federal income and employment rates
U.S. Department of Health and Human Services	Title XVIII of the Social Security Act (Medicare)	Medicare benefit payments
DOL/IRS/Pension Benefit Guaranty Corporation	Employee Retirement Income Security Act	Pension, health, and other employee benefit plans
Equal Employment Opportunity Commission	Title VII of the Civil Rights Act	Prohibitions of employment discrimination based on race, color, religion, gender, or national origin
	Americans with Disabilities Act	Prohibitions of discrimination against individuals with disabilities
	Age Discrimination in Employment Act	Prohibitions of employment discrimination against any individual 40 years of age or older
National Labor Relations Board	National Labor Relations Act	The right to organize and bargain collectively
Social Security Administration	Social Security Act	Retirement and disability payments
DOL/State agencies	Unemployment Insurance law	Unemployment Insurance benefit payments
State agencies	State tax law	State income and employment taxes
	State workers’ compensation law	Workers’ compensation benefit payments

 

The Department of Labor has taken particular interest in the worker misclassification issue. The agency has entered into partnerships with 37 states to work together on this issue in a variety of ways—for example, information sharing and coordinated enforcement (see www.dol.gov/whd/workers/misclassification).

The chart above, prepared by the Government Accountability Office, shows the principal government agencies that are concerned with misclassification of employees as ICs.

State Audits

Audits by state agencies are even more common than federal audits. State audits most frequently occur when workers who were classified as ICs apply for unemployment compensation after their services are terminated. Your state unemployment compensation agency will begin an investigation, and you may be subject to fines and penalties if it determines that your workers should have been classified as employees for unemployment compensation purposes.

If workers classified as ICs are injured on the job and apply for workers’ compensation benefits, you can expect an audit by your state workers’ compensation agency. Very substantial fines and penalties can be imposed on businesses that misclassify employees as ICs for workers’ compensation purposes. You may even face a court order preventing you from doing business until you obtain workers’ compensation insurance. (See Chapter 6
for more about state workers’ compensation laws.)

Moreover, several states, including Colorado, Delaware, Illinois, Indiana, Maryland, Minnesota, New Hampshire, New Jersey, Rhode Island, and Washington, have adopted laws that make it “fraud” for an employer to either “knowingly” misclassify its workers as ICs to avoid providing them with unemployment or workers’ compensation insurance, or fail to comply with federal or state prevailing wage and overtime pay rules.

Although not as common as unemployment insurance or workers’ compensation audits, your state tax agency may also audit to ensure that your workers are properly classified for purposes of your state income tax law. Again, fines and penalties may be imposed for misclassifying employees as ICs. (See Chapter 5 for more information about state tax laws.)

Worker Misclassification Lawsuits

A growing number of worker misclassification lawsuits are being filed by workers under state and federal employment laws. Many of these take the form of class action suits in which plaintiffs’ lawyers represent tens, hundreds, or even thousands of similarly situated workers.

The plaintiffs in these cases seek payment for employee benefits such as minimum wages, overtime pay, sick leave, health care, and vacation pay. Such lawsuits have been filed in recent years on behalf of a wide variety of workers, including Uber and Lyft drivers, truckers, delivery workers, insurance agents, janitors, telecommunications support personnel, newspaper delivery carriers, health care professionals, “crowdsourced” workers, and even exotic dancers.

Loss of Control

Another possible drawback to classifying workers as ICs is that you lose control over them. Unlike employees, whom you can closely supervise and micromanage, you have to leave independent contractors alone to do the job you are paying them to do. If you help them too much or interfere too much in their performance, you risk turning them into employees. (See Chapter 2 for more about this control issue.)

Some business owners want to be in charge of everything and everybody involved with their business. If you’re one of them, and you want to control how your workers do their jobs, classify them as employees.

Loss of Continuity

Generally, employers use particular ICs only as needed for short-term projects. This can result in workers constantly coming and going, which can be inconvenient and disruptive for any workplace. And the quality of work you get from various ICs may be uneven. One reason businesses hire employees is to be able to depend on the same workers day after day.

Restrictions on Right to Fire

You do not have an unrestricted right to fire an IC as you do with most employees. Your right to terminate an IC’s services is limited by the terms of your agreement. If you terminate an IC who performs adequately and otherwise satisfies the terms of the agreement, you’ll be liable to him or her for breaking the agreement. In other words, the IC can sue you and get an order requiring you to pay a substantial amount of money in damages.

Liability for Injuries

Employees covered by workers’ compensation who are injured on the job cannot sue you for damages. Instead, they can file workers’ compensation claims and receive workers’ compensation benefits. This is not the case with ICs. They can sue you for damages if they claim they were injured because of your negligence, such as your failure to provide a safe work­place. If the injuries are substantial and your negligence is clear, you may end up having to pay quite a bit of money in damages. When you hire ICs who perform services at your place of business, you should have liability insurance to cover the costs of such lawsuits. Depending on your situation, this may or may not be cheaper than obtaining workers’ compensation insurance.

Possible Loss of Copyright Ownership

If you hire ICs to create works that can be copyrighted—for example, computer software, book chapters, or photographs—you will not own the legal rights to the work unless you use written agreements transferring copyright ownership to you in advance. This is not the case with employees. (See Chapter 8 for information about intellectual property issues.)

Ten Myths About Hiring Independent Contractors

Common misconceptions about classifying workers include the following: 1. If I issue IRS Form 1099-MISC, the worker is an IC. An IRS Form 1099-MISC is simply a method the government uses to track and report certain types of nonemployment income. When you provide an IRS Form 1099-MISC to a worker for payment of services, it does not automatically make the worker an IC. 2. Any worker I pay less than $600 in a year is an IC. The amount paid to a worker is not, by itself, a factor in determining whether he or she is an employee or IC. 3. Part-time and temporary workers are always ICs. Employees can and do work part-time and short-term. 4. A signed contractor agreement makes a worker an IC. A signed IC agreement can help, but it will never by itself make a worker an IC. The actual practices of the hiring firm and worker are more important than the wording of an agreement. 5. Everyone else is doing it, so it’s okay for me to treat my workers as ICs. Other drivers often speed, but that isn’t a defense if you get a ticket. 6. Workers who perform similar work for other businesses are always ICs. The relationship each worker has with each business is evaluated independently. The same worker can be an IC for one business and an employee for another. 7. A worker who has a business license and business card is an IC. They can help, but a business license and a business card, by themselves, do not make a worker an IC. All the circumstances need to be considered. 8. Workers hired through gig websites are always ICs. Hiring a worker through a gig economy website like Upwork or Freelancer.com does not by itself make that worker an IC. It all depends on how you treat the worker. 9. Workers who perform offsite are always ICs. Many employees work at home, at least part of the time. With today’s technological capabilities, off-site work is consistent with any type of worker. 10. You’re safe if you hire a worker as a subcontractor through a third party. As far as the IRS is concerned, the company that benefits from a worker’s services is responsible for the proper classification and treatment of that worker, regardless of whether the worker is engaged directly or as a subcontractor.

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