If you have hired an independent contractor to perform work for you, it is possible that the IRS will view the contractor as an employee. This classification could negatively impact your business. But, there are several ways in which you can make it clearer that your contractor is not an employee.
Employee v. Contractor
An employee is subject to the organization’s control regarding what work will be done and the manner in which it is completed. Alternatively, an organization only controls the result of the work performed by an independent contractor.
The IRS uses three categories in determining an individual’s status: behavioral control, financial control, and the type of relationship. Under behavioral control, the IRS examines the type and degree of the instructions given to the worker, as well as any training provided. The more involved you are in instructing or training a worker, the more likely it is that the person will be classified as an employee. A key question is whether the company can control what the worker does and how the worker accomplishes the job.
The critical factor under financial control is whether the worker can perform services for other organizations. If the worker is free to perform services elsewhere, it is likely the classification will be that the worker is a contractor. Additionally, the following factors are also considered:
1. whether the worker assumes the risk of profit or loss;
2. whether the worker is paid hourly or by the job; and
3. whether the worker is required to make a significant investment in tools or supplies.
For the type of relationship, the IRS considers the permanency of the relationship, whether the worker enjoys employee type benefits (such as vacation or a pension plan), and whether the services provided by the worker are part of the key activity of the organization.
Steps to Take
There is action you can take to help demonstrate that someone performing work for you is a contractor and not an employee. First, enter into a written agreement with your contractor. This agreement should expressly state that you are creating a contractor relationship and that it is not employment. Additionally, be sure to exclude the worker from any employee benefit plans.
It is important to not enter into an exclusive agreement with the contractor. If the contractor is free to perform work for other organizations and you are free to have other contractors perform work similar to what the contractor does, it makes it more apparent that the worker is a contractor and not an employee.
Allowing the contractor to make decisions regarding how the work is completed or when he or she works is also helpful. Further, establish when the work and/or relationship will end. A contractor is hired to complete a specific objective and when that objective is accomplished, the relationship should end.
In most states, including Illinois, once a single “employee” is hired workers compensation insurance must be purchased. Once workers compensation insurance is purchased your payroll is audited and you are required to pay for workers compensation on any uninsured contracted workers. Organizations should get in the habit of requesting proof of insurance (or the appropriate opt out firms for firms without non-owner employees) to have on file for an eventual audit.
Another risk is employment practices liability, one of the biggest risks for a growing business. Employees have expanded rights not available to contracts and can sue for discrimination, wrongful termination and any number of federal law violations. These allegations are increasingly expensive to defend and settle. Putting proper HR controls in place to monitor things like lunch breaks and retaining a solid employment attorney to advise on the hiring and firing process can reduce risk. Purchasing employment practices insurance can protect you and your board members from personal liability.
Contact a tech startup insurance broker today to discuss building an insurance program that will grow with and protect your company.