Employees vs Independent Contractors - What's a Small Business to Do?

Have you noticed the upsurge in the number of companies outsourcing work to independent contractors? We're not talking about a gradual upsurge, either. The growth is robust and shows no sign of slowing down. The rise in independent contractors is a trend that really got traction with the so-called "Jobless" economic recovery of recent years. The late 1980's and 1990's were a time when "downsizing" swept the economy and many good people found themselves out of work through no fault of their own. Their company simply decided to "go in another direction" or "trim the fat" or even get "lean and mean." It is no surprise that many of these folks-quite a few of them, no doubt, still upset about being referred to as "the fat"-reinvented themselves and popped up a few years later as independent contractors.

The idea is pretty simple. Like temp workers, you hire an independent contractor to perform a given project for a given amount of money. That is it. No overhead, no benefits to worry about, no taxes to withhold. Nothing but straight pay for straight work and then, when you don't need them anymore, they go away without all the potential legal fuss. Try that with an employee! From the contractor's point of view, they can set their own hours, have a real say in how much they get paid, choose their assignments and complete them in any way they think best. In fact, as long as the assignment is completed on time and on budget, the employer has little or no say in how the job gets done at all. On top of that, the independent contractor can juggle multiple assignments at the same time. They have no obligation to remain "faithful" to the employer and so can take other jobs that may, because of higher pay or other considerations, take precedence over your project.

These are not issues when you hire straight employees. You are in control of employee salaries and you can count on a certain amount of loyalty. Loyalty can have a positive effect on productivity, as can a sense of belonging that comes with a regular job. What's more, having steady, regular employees will improve overall workflow since everyone knows their job (or jobs) and how they fit into the big picture. The trade-off here is that you will have extra overhead, you will have to make payroll every week and that you will go from spending most of your time practicing your trade to splitting your time between management duties and the work you love. You will also have a higher exposure to lawsuits-especially worker-related suits-and you may need to move to larger offices to accommodate your new workforce.

The biggest pitfall in the whole issue comes not from the independent contractor you decided to hire for "Project Wildebeest." No, the biggest issue comes from not understanding the legal definitions of employee and independent contractor as they relate to taxes.

According to the Internal Revenue Service, before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The tax code recognizes four different categories of such persons:

An independent contractor
A common-law employee
A statutory employee
A statutory nonemployee

It is critical that you, the employer, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors. Understand that if you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, plus a penalty.

Employee vs. Independent Contractor

The key to determining whether the person providing service is an employee or an independent contractor is the degree of control you have and independence of your hire. Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.

As a general rule, you have the right to control or direct only the result of the work done by an independent contractor. You do not have the right to control or direct the means and methods of accomplishing that result. On the other hand, anyone who performs services for you, and you control both what will be done and how it will done, is an employee. This is the case even when you give the employee complete freedom of action. What matters is that you have the right to control the details of how the services are performed.

Statutory Employees vs. Statutory Nonemployees

If a worker is classified as an independent contractor under the common law, that person may still be treated as employees by statute (they are referred to as statutory employees) for certain tax purposes if they fall into one of the four categories below and meets certain requirements for Medicare and Social Security:

A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed for you must be the salesperson's principal business activity.

Statutory nonemployees fall into two categories: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, as long as the following are true:

Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked.
Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.

You have to determine for yourself whether hiring regular employees or independent contractors works better for your company. However, whichever way you go, there will be certain tax implications that you will have to deal with and you will have to keep these business relationships straight in order to figure things out by April 15th.

So, unless you have been to this particular rodeo a time or two and know what you are doing, the best thing to do is to contact a tax professional who has experience in the area of payroll and employment, someone you trust who can guide you properly.