Many companies like the staffing flexibility independent contractors bring to their business. Contractor engagements can be short- or long-term, depending on your sales volume or client needs. Contractors don’t require employee benefits and tax withholding, saving you money and time. Furthermore, contractors typically carry their own liability insurance, protecting your company from the potential legal exposure from having additional workers.

The risk in using independent contractors is that the Internal Revenue Service (IRS) or state taxing authorities may determine in an audit that you are misclassifying your contractors, and they actually qualify as your employees. As a result, you could be required to retroactively withhold employment taxes from the contractors’ compensation, provide them with benefit plans and comply with state and federal wage and hour laws, including the payment of overtime. Depending on the degree and duration of the noncompliance, you could be assessed with fines, penalties and interest.

To avoid potential legal and tax liability, and to correctly weigh the risks and benefits of using contractors, you should understand the critical differences between employees and contractors.

Location and Control

As a general rule, contractors determine where, when and how the work gets done. They may work from their own offices, from home or at your business location, depending on their schedules and the demands of their other clients. Contractors don't typically have assigned offices or other designated workspaces at your location. They also aren’t necessarily tied to a traditional 9-to-5 schedule. Depending on the kind of work or service they provide, they may work more than eight hours a day, at night and on weekends.

Traditional employees are typically expected to work at your business location during certain designated hours or shifts. They earn overtime if they exceed those usual hours, and they work from dedicated offices or space provided to them at your business location.

As for “how” the work is performed, contractors are called “independent” for a reason. You typically hire contractors for their expertise based on the training and experience they acquired prior to working for your company. You are generally not expected to teach contractors how to do their jobs or to direct their every activity; indeed, you may not see much of your independent contractors until their work — often a specific project or set of tasks — is done. Your employees are more closely supervised and expected to follow your company’s policies and procedures. Employees are also likely to have less project-based and more open-ended job descriptions.

Compensation and Resources

You pay contractors a fee, which can be hourly, a flat fee or based on some other metric, for their services in accordance with an engagement letter or contract. You don't make payments on a regular schedule like you would pay an employee's salary, but instead make periodic payments upon the completion of specific tasks or stages of a project. You don't withhold taxes, health insurance or other benefits from the contractors' compensation – they pay for those things out of the gross fees paid to them. Independent contractors typically provide (and pay for) their own supplies and tools and aren't reimbursed by their clients for out-of-pocket expenses like work clothes, miles driven or meals. You don't give contractors paid time off, vacation, sick or personal days. They get paid only for work completed in accordance with their contract and set their own schedule as they work.

Employees typically don’t supply their own uniforms, supplies and tools — you, their employer, does so — and their compensation arrangements are not memorialized in contracts. Employees usually receive paid time off, depending on full- or part-time status and their tenure with the employer, and their gross wages are reduced by legally required tax withholding and by some portion of the cost of the benefit plans such as health insurance and pension provided by the employer.

Legal Matters

Employees are subject to, and protected by, many laws and regulations, such as federal, state and local minimum wage and anti-discrimination laws, and rules governing overtime compensation and workplace safety. Employers are also required to confirm the U.S. citizenship status of their employees. Independent contractors are generally not covered by the employee-employer regulatory system.

U.S. laws governing intellectual property (IP) generally provide that all rights in the creative works produced by employees as part of their job duties are automatically transferred to and owned by the employer. For contractors, the IP rules are reversed; contractors automatically retain all IP rights in the work product they produce for their clients unless there is a written contract designating it as a “work made for hire.”

The Facts Matter

There is no magic formula for determining when someone working for you is an employee or an independent contractor. Regulators and their auditors typically weigh the evidence on both sides in light of the specific facts and circumstances of your company’s workforce, business and industry.

In addition to the factors outlined above, auditors want answers to the following questions:

  • Does the contractor have a separate business entity or name?

  • Does the contractor have employees or work for other clients?

  • Does the contractor advertise services?

  • Can the parties produce a service contract or engagement letter and invoices for services?

Support for Employment Law and Tax Compliance

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