Misclassifying Employees as Independent Contractors ... One of the Most Expensive Mistakes of Them All
© 2021 Elena Fawkner
The time comes for every successful home-based business owner
The time has come to hire some help. OK, but what kind of help
do you need? If it's a secretary/receptionist, that's easy. You go
out and hire yourself a competent employee. But what if it's someone
to carry out specific projects such as designing a website for a
good customer you just can't service within the timeframe the
customer needs? What if it's someone to create a marketing
program to launch your business to the masses? What if it's a
bookkeeper to handle your accounts payable, receivable and
everything else in between? The difference between these types of
activities and our secretary/receptionist example is that the former
are all specific projects whereas the latter is not.
When considering whom to hire for your project work, you have a
choice ... hire a full-time or part-time employee or hire an
independent contractor. By the time you include all the add-on
costs of hiring an employee (in addition to wages or salary you need
to add on federal and state payroll taxes, social security tax,
federal unemployment insurance tax, state unemployment
insurance, workers' comp premiums and employee benefits,
not to mention shelling out for office space and equipment), hiring
an employee becomes a relatively expensive option compared to
hiring an independent contractor to do the same work. The add-on
costs of hiring an employee usually add about 30-40% to the
bill. In other words, if you pay your employee $10 an hour, you'll
really be paying $13 - $14 an hour once you include all the add-on
In contrast, although you usually pay an independent contractor
more than an employee, that cost will still be less than an employee
with the add-on expenses. You may pay an independent contractor
$12 an hour without any additional charges. Sound good? Well,
read on. It's not as easy as it looks.
WHAT IS AN INDEPENDENT CONTRACTOR?
So, what is the difference between an employee and an independent
contractor anyway? Quite simply, an independent contractor is
someone who contracts with someone else to provide specified
services for a set price on terms and conditions outlined in the
For example, let's say you hire a gardener to mow your lawn and
get rid of weeds once a week. Your contract (whether written or not)
is that Joe Gardener will arrive at your house on Friday morning,
mow your lawn, get rid of weeds and generally tend to your garden.
In exchange, you agree to pay Joe $40 for this service each week.
Joe supplies his own lawnmower, hedge clippers and weeding tools.
Joe decides what time he arrives and how long the job takes (within
reasonable parameters). You do not supervise Joe in his tasks or
dictate to him how they are to be done. Joe is an independent
businessperson and you treat him accordingly. The final product
is either to your satisfaction or it isn't. When he's finished, you pay
him if you're satisfied with the end result and you don't pay him if
Contrast this with an employer/employee situation. Let's say
you own the business Joe's Gardening Service. You employ
three employee gardeners to perform services for your business.
As the gardeners' employer, you pay them a fixed wage and you
withhold taxes, unemployment insurance and various other
benefits from their wages to remit to the appropriate government
agencies. In addition, you provide your employees with the tools
and equipment they need to perform their work. You tell them what
to do and supervise them while they're doing it. At the end of the
job they get paid by you whether your customer is satisfied with
the job or not. In other words, although your customer may not
pay you (the independent contractor) because she is dissatisfied
with the work performed by your employees, you must still pay
your employees because they are not independent contractors -
they are your employees and are entitled to be paid a fixed wage.
If you are dissatisfied with their work, you can fire them but you
can't decide whether to pay or withhold their wages based on the
end result of the particular project.
ADVANTAGES OF INDEPENDENT CONTRACTORS
As mentioned above, the main advantage of independent
contractors versus employees is cost. You can get the same
or better service from independent contractors for a lower hourly
rate than you can from employees because you don't have to
incur all the add-on expenses that go along with hiring employees.
=> Equipment and Materials
In addition, you don't have to provide office space or materials
and equipment to independent contractors. As independent
contractors (who may also go by the terms "freelancers",
"consultants", "self-employed", "business owners" etc.) are
self-employed business people, they have their own "tools of the
trade". If they're website designers, they have their own office
space, computer and printing equipment. If they're gardeners,
they have their own lawn mower, whipper-snipper, wheelbarrow
and pruning shears.
=> Legal Liability
At law, an employer is vicariously liable for the torts of his or
her employees. This means that if you hire an employee gardener
who accidentally runs over your customer's pet cat in the driveway
of her home when the customer had made it clear that your
employees are always to park in the street, in addition to suing your
employee for negligence, she can also sue you, the employer, as
you are vicariously responsible for the acts of your employees. (And,
by the way, this applies whenever your employee is acting within
the scope of employment, whether under your express instruction
or not. If your employee has a car accident when traveling between
jobs and his negligence at least partially caused the accident,
you're responsible to the same extent as the employee.)
This is generally not the case with an independent contractor unless
the independent contractor has been engaged to perform an inherently
dangerous activity (such as blasting) or you have attempted to
delegate to your independent contractor a non-delegable duty (such
as keeping a rental property you own in good repair for the benefit of
In addition to minimizing legal liability for torts, hiring independent
contractors also minimizes your liability for other types of lawsuits
such as wrongful termination or job discrimination.
DISADVANTAGES OF INDEPENDENT CONTRACTORS
There are two main disadvantages to hiring independent contractors
Far and away the most serious disadvantage is if you misclassify
employees as independent contractors. Merely labeling a worker as
an independent contractor is not enough. They must actually be an
If you do misclassify an employee as an independent contractor, you
must pay the IRS all back-taxes owed, plus interest, plus penalty
(12% - 35% of the total tax bill).
Also, you expose yourself to an increased risk of state audits when
your terminated independent contractor files for unemployment
benefits. Never mind that you and your independent contractor
intended that there be no employer/employee relationship, many's
the disgruntled independent contractor who unilaterally decides to
recategorize the relationship as one of employer/employee when
the spectre of unemployment benefits raises its pretty head. In such
situations, you'd better be able to protect yourself by proving that
the arrangement was for an independent contractor and not an
=> Legal Liability
Unlike an employee who is limited to workers' compensation
benefits, an independent contractor can sue you for negligence if
they're injured on the job. That's what liability insurance is for
DETERMINING WHETHER JOE IS EMPLOYEE OR INDEPENDENT
Unfortunately, as far as the various government agencies are concerned,
there is not one single test that determines whether Joe is your
employee or an independent contractor. Even more difficult, it is
quite possible that for the purposes of one government agency Joe is
considered to be an independent contractor while for another he is
treated as an employee.
=> The IRS/Common Law "Control" Test
The IRS follows the common law "control" test for determining whether
someone is an employee or independent contractor. This test looks
at 20 factors as being indicative (and only indicative) of whether
the person is an employee or independent contractor. The test
basically involves a balancing of these factors -- which way does the
Here are the IRS factors:
1. Whether the worker can earn a profit or suffer a loss from the
activity (if so, the more likely it is that the worker is an independent
2. Whether the worker is told where to work (indicative of employee
3. Whether the worker offers his or her services to the general
public (indicative of independent contractor status).
4. Whether the worker can be fired by the hiring firm.
5. Whether the worker furnishes the tools and materials needed to
do the work (indicative of independent contractor status).
6. Whether the worker is paid by the job or by the hour (independent
contractors are more likely to be paid by the job; employees by the
7. Whether the worker works for more than one firm at a time
(indicative of independent contractor status).
8. Whether the worker has a continuing relationship with the hiring
firm (indicative of employee status).
9. Whether the worker invests in equipment and facilities (indicative
of independent contractor status).
10. Whether the worker pays his or her own business and traveling
expenses (indicative of independent contractor status).
11. Whether the worker has the right to quit without incurring
liability (indicative of employee status).
12. Whether the worker receives instructions from the hiring firm
(indicative of employee status).
13. Whether the worker is told how to perform the work (indicative of
14. Whether the worker receives training from the hiring firm (indicative
of employee status).
15. Whether the worker performs the services personally.
16. Whether the worker hires and pays assistants (indicative of
independent contractor status).
17. Whether the worker sets his or her own working hours (indicative
of independent contractor status).
18. Whether the worker provides regular progress reports to the
19. Whether the worker works full-time for the hiring firm (indicative
of employee status).
20. Whether the worker provides services that are an integral part
of the hiring firm's day-to-day operations (indicative of employee
It is important to note that none of the above factors are, of themselves,
determinative. The IRS will balance all of the factors to determine
which side of the equation is favored.
=> Other Agencies
The other government agencies with which you need to be concerned
1. Your state Unemployment Compensation Board.
2. Your state Workers' Compensation Insurance Agency.
3. Your state Tax Department.
4. Your state/federal Department of Labor.
Unfortunately each state agency varies in its approach to determining
whether a worker is an employee or independent contractor. Many
states' agencies use a statutory test focusing on just a few of the "control"
test factors. You should therefore find out the factors that your state's
agencies take into account before hiring any independent contractors.
Most of this information will be available on the agency's website. If not,
call them and get them to send you information about their policies.
OK, so you know the difference between an independent contractor
and an employee, you know the advantages and disadvantages of
hiring independent contractors and you know the dangers of
misclassification. How do you protect yourself?
=> Independent Contractor Agreement
First and foremost, arm yourself with the IRS' control test factors and
the tests used by the various government agencies in your state.
Once you have that information, you can structure your arrangements
with your independent contractors accordingly. These arrangements
should be reduced to writing, in the form of an independent contractor
An independent contractor agreement should contain a description of
the services the independent contractor is to perform, by when they
are to be performed and the amount the independent contractor is
to receive in return for satisfactory service.
This agreement can be very helpful evidence in proving that the
worker's status was independent contractor rather than employee.
Although such an agreement is insufficient by itself (if you nonetheless
treat the independent contractor as an employee the agreement
will be worthless for this purpose), if the factors weighed by the IRS
under the control test are evenly balanced, an independent contractor
agreement may well tip the scales in your favor.
Before hiring an independent contractor, put him or her through a
few hoops first. It's a good idea to prepare some form of questionnaire
to extract the sort of information you would need to be able to prove
in support of your argument that the worker is, in fact, an independent
contractor and not an employee. Examples of such information
(courtesy of the NOLO website - http://www.nolo.com) include:
1. Whether the worker has formed a legal entity for his or her business.
2. Whether the worker has filed a fictitious business name (also known
as a "DBA" or "doing business as").
3. The worker's business address and telephone numbers.
4. The number of employees employed by the business.
5. Whether the worker has any professional or business licenses.
6. References from other business for whom the worker has performed
services as an independent contractor.
7. How the worker markets his or her business.
8. Whether the worker maintains an office separate from his or her
9. A description of the equipment and facilities the worker owns and
will use in the project.
10. Whether the worker has business cards and stationery etc..
11. A listing of the types of insurance coverage the worker has
for his or her business.
Request documents that evidence the responses to the above questions.
For example, get copies of fictitious business name statements,
professional and business licenses; references; business cards and
stationery and insurance policies.
At the end of the day, whether you hire an employee or an independent
contractor is a decision for you and your business. If you feel you can
adequately protect yourself against an allegation of misclassification
then, by all means, follow the independent contractor route if that makes
most sense to you. But if you don't feel confident in managing the
relationship to protect yourself from such a charge, for your own
peace of mind, you may be well advised to hire an employee even if
that is more expensive up-front. After all, if you get it wrong, you'll be
paying those additional costs anyway in the form of back-taxes (and
interest and penalties to boot).
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