RSM Resources

It’s common for companies of all sizes to look to independent contractors as a cost-effective supplement to their regular workforce. The problem is maintaining that independence.

Increasingly, the IRS is scrutinizing this relationship and is focusing on three primary areas of the employer-employee relationship to determine whether a worker is, in fact, independent:

• Behavioral control. Does the employer control how the work is done through instructions, training or other means?
• Financial control. Does the employer require the worker to work onsite, pay by the hour or demand a level of work that keeps the worker from doing other contracted jobs?
• Type of relationship. Is there a written contract? Does the relationship have a specified end date? Are the services performed by the worker of a specialized nature or are they integral to the regular business of the company?

Keep in mind that you need not exercise control over a contracted worker in order to have control. From the perspective of the IRS, a contractor may be considered a regular employee if you have the ability to exert behavioral or financial control, regardless of the initial intent behind the relationship.

Freedom isn’t free

At the height of the dot-com boom in the 1990s, Microsoft expanded its pool of programmers by recruiting freelance computer programmers to work side-by-side with its own employees. When the IRS audited the software giant to be sure it was in compliance with federal tax laws, it ruled that freelance programmers performing the same jobs as regular employees in the same place at the same time should be considered regular employees.

The contractors sued when they realized they had been shortchanged in salary and stock options their full-time Microsoft counterparts had earned. Microsoft paid tens of millions of dollars in back salary, unpaid taxes and the value of stock options the "contractors" would have received as employees.

The temptation to expand the duties of an independent contractor who is a good fit within an organization can be overwhelming — and quite often, the contractor can use the extra work. The appeal of hiring independent contractors is obvious — fewer taxes to withhold and pay, with no need to provide benefits. These benefits to the employer are precisely why the government monitors such relationships so closely, and the potential cost of violating government guidelines can quickly outweigh the money saved by hiring a freelancer.

The IRS 20-Factor Test

IRS Tax Topic 762 details the three areas of an employee-contractor relationship that determine whether the worker is independent: behavioral control, financial control and type of relationship. To help investigators — and employers — determine whether or not a worker is properly classified as an independent contractor, the IRS developed this20-point test, as outlined in HR Magazine. (June 2001).

• Instructions. An employer should not tell an independent contractor how to do a job.
• Training.  An employer should not provide substantial training for an independent contractor.
• Integration. An independent contractor should not be hired to provide a service that is an essential part of an employer’s business.
• Personal services. An employer should not insist that the work be performed by the contractor rather than someone that the contractor might hire.
• Assistants. Independent contractors control and pay their assistants.
• Length of relationship. Independent contractors should not have a continuing relationship with an employer unless there are multiple contracts.
• Work hours. An independent contractor usually determines the hours worked to complete a job.
• Amount of work. An independent contractor should not be told to work full time for an employer if that would prevent the contractor from doing other work.
• Location. Unless the services can be performed only in one location, an independent contractor chooses where to do the work.
• Sequence of work. Independent contractors determine the order in which they accomplish their tasks.
• Reports. Independent contractors should not be required to produce interim reports.
• Payment. Independent contractors are paid for the results of their work, not for the time worked.
• Expenses. Independent contractors are responsible for their business expenses.
• Tools. Independent contractors typically provide their equipment and tools.
• Investment. An independent contractor has a significant investment in his business, such as a home office.
• Profit. Independent contractors can realize profits and incur losses.
• Multiple jobs. Independent contractors can work for more than one employer at a time.
• Availability. Independent contractors make their services available to the general public.
• Termination. Independent contractors cannot be fired at will, as can employees.
• Liability. Independent contractors are liable for failure to complete a job.

Get it in writing

Pete Fornal, an independent contractor expert for the Society for Human Resource Management (SHRM), says the contract is the key to maintaining the contractor’s independence.

"Most organizations that hire a contractor directly have a standard, legal agreement that clearly delineates that this person is an independent contractor and will receive a 1099 (the tax form needed by the contractor to file his or her income taxes)," Fornal says. "The contract should include a clause that provides a specific timeframe for the relationship, and a specific project to be completed."

Fornal added that how the contractor is paid depends on the general practice of the employer and the preference of the contractor — but that this, too, should be clearly defined in the contract. In a written SHRM legal report titled "Independent Contractors v. Employers:Guess Who’s Coming to Work!" Gary C. Pierson describes three typical payment scenarios for independent contractors:

• The person employed performs the work for a lump sum.
• Payment is calculated according to the quantity of work performed.
• Compensation is calculated, either entirely or in part, based upon the amount which has to be disbursed in order to perform the work.

Hourly compensation, on the other hand, is considered indicative of regular employment.

"It comes down to due diligence," Fornal says. "Make sure the attorneys review the contract, and that it clearly defines the worker as a nonemployee, but still contains protections for your business like a nondisclosure clause and a statement about confidentiality."

Although a well-written contract is the foundation of a good employer-contractor relationship, it is not enough unless you stick to it. Pierson says even the beliefs of the parties are not enough to define a worker as independent.

"The intent of the parties is a factor to be considered, although it certainly is not controlling," he says."Courts generally will not interfere with the parties’ intent if they have defined their relationship and the facts of the relationship support the arrangement. In close cases, courts will often defer to the parties’ view of the arrangement. But the beliefs and intentions of the parties are not determinative where other evidence is to the contrary. A contractual provision defining an independent contractor relationship is basically worthless without support from the surrounding circumstances."

The bottom line? Stick to the plan — and when the project is done, go your separate ways until the next project comes along.

The agency alternative

For companies looking to hire an independent contractor but wanting to avoid potential problems, Fornal offers an alternative solution: hire through an agency. Employment agencies such as Kelly Services and Manpower provide workers with a wide range of education and skill levels — from manual laborers to chemists with doctoral degrees.

"When you go through an agency, it handles how employees are paid, and in some states, assumes the responsibility for workers’ comp claims," Fornal says.

Potential disadvantages include cost and the quality of contractor available. According to Fornal, employers should still screen agency-provided employees thoroughly and verify references whenever possible.

By following these simple guidelines, you will help ensure that your independent contractors remain independent under the eyes of the law.