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Hiring Contractors Instead of Employees

Bringing on small business contractors to get work done at your company can be a very efficient way to quickly access workers and talent. Also, using contractors rather than employees saves the business considerable expenses related to employee benefits and taxes.

How Do You Save Money by Hiring Contractors

Employers save a considerable amount of money using contractors instead of employees. The savings result from:

Payroll Tax Savings - Employers pay an additional tax when they pay employees. This tax is the "employer's portion of payroll tax." This is tax money that employers pay which is equal to what the employee pays for Medicare, Social Security, and Disability. This is also called, the employers "matching tax contribution."
Employee Benefits - The employer does not have to provide benefits to small business contractors including healthcare insurance, retirement benefits, and performance incentives.
Worker's Compensation - Employers do not need to pay for this when using small business contractors.
Related Expenses - There are a number of expenses related to having employees that are not required for contractors such as: computers, supplies, office expense, telecommunications, training, and other HR related expenses.

Important: Small Business Contractors or Employees – the risks are great if you are wrong!

It is the first group of savings listed above, related to employer payroll taxes, that leads to the IRS rules about contractors. Because employers are able to avoid taxes by calling their workers “contractors” rather than employees, the IRS will scrutinize your worker classification. You need to make sure your workers are in fact contractors under IRS Standards.

If you are not careful about this, you could end up paying fines, taxes, and, adding insult to injury, even the taxes that the “employee” should have paid (i.e. employee's portion of payroll tax.)

Real World Example

You are a new company and bring on your first worker. The two of you agree verbally that the relationship will be that of a contractor.

Because you are moving quickly, you don't have any special agreement signed. Later, you find out that the IRS wants to know where the payroll taxes are for this worker. Also, this worker never saved any money from what you paid them to pay for their own taxes.

The worker claims that they were an employee and that you as the employer where responsible for withholding taxes. The IRS makes you as the employer pay the employee's taxes, they also make you pay the employer portion, and they charge you penalties and interest.

Add to this situation, if you have any type of falling out with the worker. Let's say they are not as skilled in the technology as they claimed or they show up late to work all the time, or maybe they are just a pain in the neck to work with. There are many scenarios where this relationship can blow up in your face.

There are many things that you can do to protect yourself. You can very easily find a small business contractor agreement using an Internet source. But that does not guarntee you protection under the IRS rules. That's because the IRS have their own set of rules for determining whether a worker is an employee or a contractor and simply having a contractor agreement is not enough.

IRS Definition of Contractors

The IRS has a set of considerations that it reviews in determining whether a worker you pay is, in fact, an independent contractor. The following are the guidelines that the IRS considers:

The Key IRS Test: Degree of Control Over the Worker

How much control do you as the company exercise over the worker (and in a reciprocal way the amount of independence of the worker.) According to the IRS, a true contractor is a worker whom you have the RIGHT to control ONLY the result of their work and NOT the means and methods of accomplishing the result.

On the other hand, if you have the “right” to control what and how work will be performed, the worker is classified as an employee. Importantly, even if you give the worker freedom in how they work, but you still have the “right” to control their work then the worker is an employee.

How Does the IRS Test “Degree of Control?”

So how does the IRS determine whether you are exercising control over what and how work is performed? The following are a number of general tests that the IRS uses to understand whether the worker is an employee or contractor.

You stipulate how work must be performed and not just the deadline when work is due.
You tell the worker where the work must be performed (such as in the office rather than anywhere the worker would like.)
You insist what software, equipment, utilities, and other tools must be used to get the job done.
You control who else the worker must use to get the job done in terms of other contractors or subcontractors.
You direct where to purchase key inputs such as hardware, software, supplies, and other services.
You specify the order with which work must be carried out.

Keep in mind, its not any one of the above issues that will flag a worker as an employee rather than a contractor. Nor is it that all the above must be true for the worker to be considered an employee. Rather, its more a body of information related to the above that will move the IRS to conclude your worker's are contractors.

Small Business Contractor Examples

Given the above, what are some real world examples that you need to watch out for when hiring contractors?

Indicates the Worker is an Employee

Does the worker use their own computer or a company computer. If the worker uses your computer this is an indicator that they are an employee.
Does the worker have to show up at your office each day, every day, at a specific time? An independent contractor would not do this. A small business contractor might show up for certain meetings or generally show up at a certain time everyday but they should not be required too do so day in and day out.
Does the company provide special training to the worker or pursue certain enrichment activities with worker? This is done with employees and not when hiring contractors.
Does the company provide the worker with benefits such as health insurance, retirement plan, vacation time, sick time, etc? These are not things provided when hiring contractors.
Are the services performed by the worker a core aspect of the business and therefore something that is clearly need on a continual, ongoing basis?
Does the worker get reimbursed for business expenses? According to the IRS, employees get reimbursed for exampenses realted to their job whereas contractors are more likely to have un-reimbursed expenses.

Indicates the Worker is an Independent Contractor

Has the worker made significant investments in being able to provide services to the company? This is something that contractors rather than employees do.
Does the contractor actively market their services to more customers than just the company with which they are currently working? According to the IRS, the extent to which the worker makes his or her services available is a key test of their independence.
How do you pay the worker? This is another indicator reviewed by the IRS. According to the IRS, employees are guaranteed a regular wage amount for a period of time. When hiring contractors, they are usually paid a flat fee per job. As a result, if the contractor is smart or efficient about how they get the work done, the Contractor should be able to make more or less profit as a result.
Do you have a specific written contract agreement between the company and the worker? You should when hiring contractors and the contract should stipulate a contractor arrangement.
How permanent is the worker to your business? Does it look as though you are planning on engaging with the worker indefinitely or for a specific period of time? Independent Contractors should be engaged for a specific time period.

Important: Who Owns The Creative Work - Contractor or Company? Does the independent contractor own their creative work or does the company? Without special provisions in the agreement with the independent contractor, the company may not have ownership rights over creative works. This is not true with employees.

This is Important! You will need to have provisions in your agreements if you are concerned about owning the creative output of work from a contractor.

To ensure ownership over things like computer programs, websites, photographs, designs, etc, you and the contractor must agree to assign all of the copyright rights to you. Be sure to put this in the agreement with the contractor in advance of any work commencing.

Small Business Contractor Tax Obligations

At the end of the year you will need to file a form 1099-Misc with the Government and send a copy to the contractor. This is a requirement and basically tells the Government that a worker was paid money for contractor work performed.

So, if a contractor does not report an equal amount of income from your company, this is how the Government will find out. The Government requires you to create a 1099-Misc for each contractor that you have paid at least $600 in any given year for services performed for your business.

1099-MISC and W-2: What's the Difference? As an aside note, the money that you pay employees during the course of a year are reported to the Government via a copy of the W-2. The W-2 must be issued to the employee at the end of the year and a copy sent to the Government. So, a 1099-MISC is sort of like a W-2 but for contractors.

1099-MISC Filing Timeline The company is required by law to send the 1099-MISC to each contractor by January 31st. Also, the company must send a copy of the 1099-MISC to the Government by the end of the following month, February 28.

Small Business Contractors In Summary As discussed, you as the employer save a great deal in employer taxes when you have independent contractors rather than employees. However, there are strict rules that test whether a worker is in fact a contractor rather than an employee.

If the Government ever reviews the status of your small business contractors and employees and determines that your are paying someone as an independent contractor who under the test really an employee you could be liable for tax penalties which may include paying for the “employees” payroll taxes. So you must be very careful about this.

Hiring Small Business Contractors - Note to the Department of Labor Final note, in some states, any business that hires Independent Contractors is also required to report contractors to the State Department of Labor. This is done in a similar way to how employees must be reported. For the same reason, it is done in order to identify parents who are delinquent in paying child support. Check with your state Department of Labor for more information about small business contractors.

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