How to Manage Independent Contractors

Decide Whether You Need One

Goal:
Learn what contractors can do for you — and when it makes sense to hire one.

Independent contractors (ICs) are workers who provide their
services to the public, usually on a short-term or part-time
basis. They work with multiple clients, operate out of their
own workplace, have their own tools and equipment, and may
have a business license or a company name.

Generally, it makes sense to go the free-agent route when you
don’t have enough steady work to justify a permanent position. Here
are the top three reasons companies hire ICs instead of employees:

The task requires specialized skills.
You don’t have these skills on staff and you won’t
need them long term.

Examples:
You bring in an interior designer to redesign your offices or
an IT expert to set up a new server.

The task is short-term.
The job at hand will take a few weeks or months to complete.

Examples:
You need extra programmers on hand for the launch of your website
or an employee is taking a temporary leave of absence.

The workload fluctuates.
The flow of work is not consistent enough to warrant creating a
permanent staff position.

Examples:
You need an accountant who can put in 180 hours a month during tax
season but only 50 hours in June, or you bring in a landscaper to
plant every spring, but there’s very little for her to do in fall and winter.

Learn the Legal Definitions of Contractor and Employee

Goal: Know the law, so you don’t end up
breaking it.

Let’s say you’ve decided that hiring an IC
is the way to go. Now you need to make sure the work arrangement won’t
raise any red flags with the IRS. Just labeling the person a contractor and
signing an agreement, for example, isn’t enough. According to the
IRS, a manager hiring a contractor has the right to control or direct only the result of the work — not the method of accomplishing it. That means the
managerial relationship between you and your worker is the IRS’s prime
concern. Because work situations can vary so widely, the IRS does not publish
specific guidelines, but here are the three factors the agency looks at:

Behavioral Control

Who decides where and what time the
person works, what tools or equipment they use, or which subcontractors to hire
to assist with the work? Who is responsible for training?

Examples: An independent trucker is a contractor if you hire him to make deliveries using his own truck and he sets his own
schedule and hires his own assistants. The driver is not a contractor
if you give him a daily schedule, a driving partner, and the truck to make
the deliveries.

Financial Control

To what extent does the worker have
unreimbursed expenses or make services available to the public? Can the worker
make business decisions that would affect their profit or loss? Are they paid
regardless of whether the work is completed?

Examples: A cabinet maker is a contractor if she
contracts with your company to do a job for a fixed fee. She buys her own
materials and tools, and makes a profit only if she has charged you more than
her costs. The cabinet maker is not a contractor if you buy the
materials, rent the tools, pay her regardless of whether the work was
completed, or ask her to give up other work opportunities while working for
you.

Type of Relationship

What is the relationship between
the parties? Are there written contracts describing the relationship? Is the
worker provided with benefits or insurance? How permanent is the relationship?
How integral are the services to the company’s principal activity?

Examples: An accountant is a contractor if she has
her own accounting firm and you and she both sign a contract stipulating that
she will provide accounting services to your restaurant for a fixed monthly fee.
The accountant is not a contractor if your company is an accounting firm
and she is a retired employee who is still covered by your workers’ comp
and disability insurance.

Know the Risks of Misclassification

Goal: Avoid legal problems with the IRS — and your workers.

By now you know what to expect from the IRS: If they conduct an
audit and find you in violation of worker misclassification, you’ll
owe back taxes and penalty fines. But the danger in misclassification doesn’t
end there. Workers themselves may take issue with the classification if it
denies them rights or benefits they feel they are entitled to.

When the IRS audited Microsoft in 1990, the company quickly
agreed to settle and reclassified approximately 600 independent ICs as
employees. Though the workers had signed agreements saying they were
freelancers, many of them did the same work that was done by employees of the
company. They were also supervised and in some cases worked exclusively for the
company for as long as 10 years. Microsoft ended up paying millions in back
taxes and fines, but that was just the beginning. The reclassified workers —
forced to refile taxes, pay interest and penalties, and renege years of business
expenses — sued Microsoft to recover benefits they had been denied
while classified as ICs, including 401(k) pension benefits and the right to
participate in the company’s employee stock-purchase plan. The $97
million settlement ended up costing the company more than the original audit.

Time Warner Inc. had similar problems in October 1998, when the
Pension and Welfare Benefits Administration of the U.S. Department of Labor
sued the company, charging worker misclassification of hundreds of employees as
independent contractors or temporary workers. The misclassification had denied
the workers benefits in violation of the Employee Retirement Income Security
Act. In November 2000, the two parties announced a $5.5 million settlement.

Today FedEx finds itself in a similar position. In addition to
the $319 million IRS audit, the company is also fighting more than 50 lawsuits
brought by drivers in 36 states. Though hired as ICs, the drivers say that they
are managed like employees — the company holds them to specific
schedules and customer-interaction policies — and therefore should be
entitled to benefits and reimbursement for expenses and lost wages.

Take Advantage of IRS Amnesty

Goal: If you’re out of compliance, find out whether you qualify for tax relief.

One catch-22 with these rules is that when companies realize
they’ve been breaking the rules, they’re often reluctant to
reverse course for fear of attracting attention. To ease the pain, the IRS has
developed a few programs that can help relieve the tax burden for employers who
have made classification errors.

Total Relief: If you qualify for Section 530 under the
Revenue Act of 1978, you will not owe any past employment taxes and you can
continue to treat workers as ICs. The three requirements are:

1.You have a reasonable basis for treating a contractor as an
employee (i.e., you based your decision on a similar instance in a tax-court
case or on what other companies in your industry do).

2.You have treated all similar workers as contractors.

3.You have filed all taxes consistently (i.e., you always filed a
1099 for the contractor).

Partial Relief: For companies that don’t
qualify for Section 530 relief, the IRS will conduct an examination under the
1996 Classification Settlement Program. If they determine that you’re
eligible, they’ll offer you the chance to reach a settlement rather
than go to tax court — as long as you agree to get in compliance.
Offers include settling for a single year of taxes or 25 percent of one year of
taxes, if certain requirements are met.