Key Takeaways

  • An internal contractor is an independent professional who performs services for a business without being treated as a traditional employee.
  • The IRS examines control over work, financial relationship, and benefits to determine contractor status.
  • Internal contractors typically do not receive benefits or employment protections.
  • Misclassification of employees as contractors can result in severe penalties and back taxes.
  • Contracts should clearly outline the nature of the relationship, project terms, and payment structures.
  • Legal tests like the IRS Common Law Test and the “ABC Test” are key to determining proper classification.

An internal contractor, also referred to as a consultant, is a freelancer who doesn’t work as a permanent employee of the company he is doing work for. While there seems to be no difference at all in terms of working alongside employees and doing the same type of work that employees do, there are some key legal differences between an employee and an internal contractor.

It is common for companies to employ internal contractors in a number of job functions, including lawyers, doctors, writers, web content designers, secretaries, painters, electricians, and more. However, when companies choose to hire such individuals, they should be mindful of the requirements for identifying them as internal contractors and not employees of the firm.

Internal Contractor Defined

When determining if an individual is an internal contractor, the Internal Revenue Service (IRS) will look at 3 elements:

  • Control over the work
  • Financial control
  • Relationship

A company will enter into a contract with its employees by stating what type of role the employee has, and the type of work that is expected under the employment contract. Therefore, if the employee does a certain amount of work every day, with no variation in hours or scope, then he will be considered an employee. However, if there is less control over the person, and the work is being done over different days, weekends, and hours, then he will be classified as an internal contractor.

If the company has less financial control over the individual, then it will likely deem that person an internal contractor. Therefore, the IRS will look to how the person is paid, how taxes are paid, etc. If the person receives benefits and an annual salary from the employer, he will be considered an employee.

The IRS will also look at the overall relationship between the company and person. Does the person benefit in any way from what is being offered by the company, particularly in terms of insurance and other vacation benefits? Does the person work for another company? If they determine that the employee has several contracting jobs, then the employee will be considered a contractor.

Legal Framework and Classification Tests

Proper classification of a worker as an internal contractor or employee is governed primarily by the IRS and state-specific legal tests. The IRS Common Law Test considers three key categories:

  1. Behavioral Control: Does the company control how, when, or where the worker performs tasks?
  2. Financial Control: Are business aspects such as reimbursement, investments, and payment methods dictated by the company?
  3. Type of Relationship: Is there a written contract? Are benefits offered? Is the relationship ongoing?

Some states apply the ABC Test, especially for wage and hour laws. Under this test, a worker is considered an employee unless:

  • A: They are free from control or direction;
  • B: They perform work outside the usual course of the business; and
  • C: They are engaged in an independently established trade or profession.

Misclassification can lead to audits, penalties, and liability for back wages, taxes, and benefits.

Employee vs. Internal Contractor

There are many factors that one can look at to determine if someone is an employee or internal contractor. A contractor should be aware of the differences in what is being offered. Such differences can include the following:

  • How taxes are paid
  • How the company pays the person, i.e., hourly/salary/project pay
  • What type of benefits one can receive
  • The duration of the contract, i.e., permanent vs. 6-month contract

Employers are responsible for paying Social Security and Medicare tax, unemployment insurance, along with workers’ compensation insurance, to all employees. Because of this, the company has to properly classify each payee as either an internal contractor or employee, providing W2s for those employees of the company. For example, anyone who provides internal services for others are generally classified as internal contractors on IRS forms. Contractors, however, pay their own Social Security and Medicare tax, with no help from the company. Furthermore, contractors cannot benefit from workers’ compensation or unemployment insurance.

Keep in mind that properly classifying employees and contractors is important; businesses might want to classify an employee as a contractor to evade minimum salary requirements and overtime pay. However, this can cause significant penalties.

While the company provides the work hours and salary for employees, the internal contractor usually works on a project basis, taking as much time as he needs in order to get the job done. Such projects are generally paid for overall, meaning that the internal contractor usually won’t receive an hourly fee. Rather, the project as a whole will be expensed to the company. If additional work is done, the contractor might receive additional income.

Employees will be supplied with the tools they need to do the job, i.e., computer, work desk, phone, etc. Internal contractors, however, might be required to supply their own equipment. Employees will receive benefits, including health, dental, and disability insurance, vacation and sick time, etc. Contractors will not benefit from these perks.

Generally, employees are hired on a long-term, permanent basis, whereas internal contractors might be hired for a specified period of time.

Common Roles and Use Cases for Internal Contractors

Internal contractors are used in a variety of industries and roles, particularly when businesses need specialized expertise on a flexible basis. Examples include:

  • Creative Professionals: Copywriters, graphic designers, video editors
  • Technical Experts: Web developers, software engineers, data analysts
  • Administrative Services: Executive assistants, virtual assistants
  • Legal and Compliance: In-house counsel on retainer, HR consultants
  • Medical Professionals: Contract physicians, therapists, and specialists

These contractors are typically brought in for project-based work, seasonal demands, or to support growing businesses without committing to full-time hires.

Risks of Misclassifying Internal Contractors

Classifying a worker as an internal contractor when they functionally operate as an employee can result in significant legal and financial consequences, such as:

  • IRS penalties for unpaid payroll taxes
  • Liability for unpaid overtime or minimum wage
  • State-level fines for unemployment insurance and workers’ comp violations
  • Lawsuits for wrongful termination or benefits denial

Employers should conduct regular audits and consult legal counsel to ensure they are meeting both federal and state requirements. The Department of Labor and state labor agencies can audit companies based on complaints or red flags like issuing multiple 1099s.

Best Practices for Working with Internal Contractors

To maintain proper classification and reduce risk, businesses should consider the following:

  • Use a written contract that outlines the scope of work, timeline, payment terms, and independent status.
  • Avoid treating contractors like employees, including restricting work hours or providing benefits.
  • Allow contractors to control their work methods and to work for other clients.
  • Ensure tax compliance, including issuing Form 1099-NEC if payments exceed $600 in a calendar year.
  • Revisit contractor relationships regularly to ensure that evolving work arrangements don't shift them into employee status inadvertently.

Clear documentation and independent work structures go a long way in supporting a contractor classification.

Frequently Asked Questions

  1. What is an internal contractor?
    An internal contractor is an independent worker hired by a company to perform specific tasks or projects without being considered a formal employee.
  2. How do I determine if someone is an internal contractor or employee?
    The IRS uses three categories: behavioral control, financial control, and the overall relationship. State laws may apply the ABC test.
  3. Can internal contractors receive benefits?
    No, internal contractors typically do not receive employee benefits like health insurance, paid leave, or retirement plans.
  4. What are the risks of misclassifying an internal contractor?
    Misclassification can lead to IRS penalties, back taxes, unpaid wages, and potential lawsuits or audits by labor agencies.
  5. Do internal contractors pay their own taxes?
    Yes, internal contractors are responsible for self-employment taxes, including both the employer and employee portions of Social Security and Medicare.

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