How to Legally Use Independent Contractors in Your Business

How to Legally Use Independent Contractors in Your Business

by Bob Kieserman

In the course of any given month, you are probably dealing with a wide range of people who come into your company to perform work, but whom are not your employees. They may be plumbers, electricians, HVAC contractors, contract cleaning services that vacuum the rugs and polish the floors each night, consultants of all types, training companies, and a host of other folks who provide advice or labor to your company as outside contractors. Just as there are many guidelines when working with your employees, there are also many guidelines that must be followed when working with any of these individuals. The key is to know how to work with both categories of workers.

Who is an employee?

One of the most distinguishing differences between employees and independent contractors is a legal concept called the fiduciary relationship. Based on the law of agency, the fiduciary relationship places an obligation of loyalty upon each of your full-time and part-time employees. Your company employees must adhere to an assigned work schedule, they must keep company matters and strategic plans confidential, and they are obligated to perform their jobs with complete loyalty to the employer. The employer has the obligation to pay the employee on a pre-determined schedule, to make the workplace a safe and pleasant place to work, and to carry out the terms of an employment contract. This includes withholding certain taxes on behalf of the employee and sending those funds to the appropriate tax authorities, paying employer taxes like federal unemployment compensation and Workmen’s Compensation as well as the employer’s FICA contribution. In addition, this fiduciary relationship dictates that the employer is legally liable for whatever the employee does or says in the course of the workday, and so, in many industries, liability or malpractice insurance must be carried by the employer.

Employers also see a need to offer some kind of benefits package to attract workers and retain them. While this is not a federal obligation, many companies do offer some level of health care coverage to their employees as well as other benefits like retirement plans, life insurance, child or adult daycare, tuition remission, and parking and/or transportation services.

Employers are also obligated to reimburse employees for any out-of-pocket expenses related to work. At the end of the year, the employer provides the employee with a W-2, which is a legally required summary of gross wages and deductions. The W-2 form is then used by the employee to complete his or her personal tax return.

One of the major elements of the employer-employee relationship is that the employer has the right to control the work of the employee – when the work is performed, how it is performed, the scope of the work performed, and the policies and procedures that must be followed. Often, the parameters of that relationship are documented in a formal employment agreement either in the form of a contract and/or a policies and procedures manual.

A popular clause of that agreement that benefits the employer is a restrictive covenant. In the case of company employees, the restrictive covenant or a non-compete clause legally prohibits an employee from disclosing confidential information about your company’s strategic plan to other companies. The company can also prohibit an employee who resigns from your company to work for another company for a certain period of time within a certain geographical area. Because the courts do not wish to deprive your former employee from earning a living, there must be a legitimate business reason why the restrictive covenant has been signed. Depending on the industry, there are legitimate reasons why a company would prevent a former employee from seeking a position with another company, and prospective employees may be asked to sign a restrictive covenant, especially if a business organization feels that the employee has had access to trade secrets and sensitive competitive information.

In all cases, every employee is said to work for the employer.

Who is an Independent Contractor?

Conversely, an independent contractor works with the company. Therefore, it is said that the independent contractor and the company have an arms-length relationship. A true independent contractor must be established as a legitimate business with a business name, business accounting records, a declared legal form of ownership (sole proprietorship, partnership, corporation, or limited liability corporation), a legitimate place of business, business stationary, and ideally, an Employer Identification Number (EIN). Most importantly, the independent contractor must be able to demonstrate multiple sources of 1099 income. During the course of the calendar year, she must be sure to perform work for other customers in addition to your company. Your company cannot be her only source of business income.

The 20-Point Test of the IRS

Many years ago, the Internal Revenue Service established a list of questions with which they test the relationship between the hiring organization (the company) and the independent contractor (IRS Rev. Rul. 87-41). The questions test the concept of control since the organization cannot demonstrate any control over the work of the independent contractor. Therefore, if you are using independent contractors during the year, it is essential that both parties (the company and the independent contractor) pay attention to these guidelines.

  1. Instructions – the company may not dictate when, where, or how the work is performed. You may tell the independent contractor the date and time frame in which you would like the work performed, but you may not tell the independent contractor how long the work should take or how it should be done.
  2. Training – the company may not provide training of any kind to the independent contractor. If the independent contractor requires training to perform the job, he must get that training on his own time at his own expense.
  3. Integration – the work performed by the independent contractor may not be as integrated into the daily operation of the company as is the work of the employee. Therefore, independent contractors should be performing special services not typically performed by part-time or full-time employees.
  4. Personal Services – the company may not exert any control over the work of the independent contractor.
  5. Use of Assistants – if the independent contractor requires assistants in performing the job for which she was engaged by the company, the independent contractor must hire her own employees and may not depend on the help of a company employee. The independent contractor is therefore solely responsible for her employees – their liability, their taxes, their benefits, etc.
  6. Ongoing Relationship – the IRS has the right to question a long-term ongoing relationship between the company and the independent contractor. Therefore, a company should have agreements with every independent contractor it uses that specifically spell out each individual project. Ideally, there should be a different agreement for each project that the independent contractor undertakes with the company. A company does not want it to appear that the independent contractor works every day with the company for an extended period of time. That could be construed as an employer/employee relationship by the IRS.
  7. Fixed Hours of Work – the independent contractor should determine his hours of work, not the company. The company and the independent contractor can mutually schedule when the work will be performed, as in the case of an entertainer or a contract cleaning service, but the independent contractor should perform the work and then leave the premises. This rule says that the company cannot force the independent contractor to work a set schedule of hours as would an employee.
  8. Full-Time Work – an independent contractor may not work full-time for a company since this negates the entire concept of using independent contractors. If the IRS believes that the independent contractor is working a full-time schedule, the IRS has the right to contest the independent contractor status of the worker.
  9. Work Location – an independent contractor cannot be forced to perform all of her work at the company. Rather, it is common for certain aspects of the work to be performed offsite such as report writing, invoicing, and preparing for the work that will be performed.
  10. Work Flow – the independent contractor must set his own time table for completing the work. The company can request that the work be performed on a given day and/or time, but the company cannot dictate the method or time table of performing the work.
  11. Reports – the company cannot force the independent contractor to complete reports used by employees. Rather, the company can request that the independent contractor provide a report of his work, but the report is drafted according to the protocols of the independent contractor.
  12. Manner of Payment – the independent contractor must be paid according to a pre-determined flat fee or hourly rate. No taxes are taken from the payment. The check is not part of the company’s payroll system. While employees must be paid according to a strict pay schedule (weekly, bi-weekly, monthly, etc.), independent contractors must submit an invoice to the company and the company can issue the check whenever it wishes. It is common for invoices to be approved at the monthly board meeting of the company.
  13. Payment of Expenses – the independent contractor is totally responsible for her own expenses, and may not receive any reimbursement for expenses from the company. Therefore, it is incumbent upon the independent contractor to pre-determine her expenses before she quotes her fee for the engagement so that the anticipated expenses are included in the stated fee.
  14. Providing Tools and Equipment – ideally, an independent contractor should not use any tools or equipment belonging to the company, but rather use only the tools and equipment that belong to the independent contractor.
  15. Investment – it is assumed that the independent contractor assumes total financial risk in the event of a loss. This means that if the independent contractor quoted a fee that turns out to be too little for the work that is performed, the company is under no obligation to pay the difference to the independent contractor.
  16. Profit or Loss – it is assumed that like any other business entity, an independent contractor can realize a profit or loss from the work performed for the company.
  17. Multiple Clients – this is perhaps the most important factor for both the independent contractor and for the company. The independent contractor must make sure that he has performed work for more than one customer during the calendar year. How many? The more, the better. At the same time, any company using independent contractors should make it a policy to determine from every independent contractor the company uses during the year, that he or she has fully complied with this requirement of having multiple clients, and that the independent contractor has, in fact, performed work for other customers in addition to the company.
  18. Marketing – like any other business, the IRS expects every independent contractor to be actively looking for new business. Therefore, it is wise for a company to periodically ask an independent contractor if they are developing new business.
  19. Right to Discharge – the law of independent contracting states that a company cannot terminate an agreement with an independent contractor unless the terms of the agreement have been breached by the independent contractor. Therefore, it is essential that every engagement into which a company enters with an independent contractor be in writing, be clear in terms of the responsibilities of both parties, as well as clear in terms of fees, payment schedules, and other particulars of the engagement.
  20. Right to Quit – an independent contractor can be sued for non-completion of a project. Just as a company cannot dismiss an independent contractor if the terms of the agreement are being met, an independent contractor cannot refuse to perform the work that he promised to perform.

Taking Precautions

If a company is using independent contractors, it is important to openly disclose that fact to your customers and to your employees since any issue involving liability must be clearly clarified. If a mechanic or any other independent contractor should cause harm to a customer, unless the customer was made aware of the fact, the customer has every right to believe that the perpetrator is an employee of the company. Therefore, it is important for company managers to insist that independent contractors identify themselves by wearing a different uniform or nametag to indicate to the public that they are not, in fact, company employees. Another issue about which company managers need to be aware is that independent contractors have the right of assignment, which means that they can assign their responsibilities to another independent contractor, often without the consent of the company. For instance, a contract cleaning company may every few months shampoo the rugs in the company. But instead of doing the job themselves, the contract cleaning company may assign that job to a specialist. If something should go wrong with that job, the liability would fall upon the contract cleaning company. However, it would be important for the company to be aware that the job was assigned. Therefore, companies should try to include a clause in their agreements with the independent contractors they use that either outright prohibits the independent contractor from assigning aspects of their contract with the company or, at the very least, obligates the independent contractor to alert the company before assignment is made.

Another issue that sometimes occurs is when a part-time or full-time company employee is also used as an independent contractor. For instance, a member of your maintenance staff who works at your company throughout the week may have a side business where he does carpentry on the weekends. According to the IRS rules, the company would not be able to use this individual as a carpenter anytime during the weekend since a person cannot be both an employee and an independent contractor for the same organization. 

The Advantages

The advantages of using independent contractors are that you only use them when you need them, you do not need to pay the payroll taxes on their fee, you are not liable for their actions, and it is usually less expensive to pay the fee of an independent contractor who is providing a occasionally needed service than to keep an employee on the payroll and be subject to the employer taxes and the employer liability.

The bottom line is that companies using independent contractors need to be careful that the relationship between the company and the independent contractor is truly an arms-length relationship, where both parties are doing what they are obligated to do in compliance with the Internal Revenue Service guidelines. Finally, at the end of the year, the company should issue a Form 1099 to every independent contractor that performed work for the company to further substantiate this relationship.


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