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|Using Contractors: The Benefits And Risks For Client Companies|
The purported benefits are balanced by significant risks to the client company. These risks significantly color the relationship between client and contractor, and explain why clients tend to adopt a "hands off" attitude in dealing with their contract workers.
The client company also runs the risk of being audited by one or more government agencies seeking to recover uncollected fees, taxes and penalties, or attempting to enforce applicable regulations, laws and court rulings affecting the status of employees.
A company that is found by the IRS to have misclassified employees as independent contractors may be responsible for paying all withholding taxes, plus interest, even if the workers already paid the taxes themselves. In addition, the IRS may impose financial penalties on the owner and company officials totaling several hundred thousand dollars, and press criminal charges with a penalty of several years in prison. Adding insult to injury, the EDD and other government agencies may impose additional penalties to those levied by the IRS.
There are two primary reasons why the IRS is so aggressive at uncovering misclassified employees:
Companies are at greatest risk of being audited by the Internal Revenue Service or the Employment Development Department. Other agencies that may become involved are the Workers Compensation Appeals board, Immigration and Naturalization Service, U. S. Department of Labor, and the State Labor Commissioner.
Each agency has developed its own list of guidelines and rulings to help employers determine the employment status of their workers. Unfortunately, the rulings of different agencies are often contradictory, and the courts are quite unpredictable.
The IRS has distilled the findings of hundreds of rulings and court cases into a list of twenty common law factors which can be used on a case-by-case basis to determine whether a contract worker is actually an employee. The IRS list of twenty common law factors is more comprehensive than the other agencies' lists, and is the most frequently consulted by hiring companies.
|The Twenty Common Law Factors|
Under the common law, a worker is an employee if the hiring firm (that is, the person or persons for whom services are performed) has the right to control and direct the way they work, not only with regard to the final result, but also with regard to the details of when, where, and how the work is done. According to the IRS, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.
The above list is adapted from IRS Revenue Ruling 87-41 Listing the 20 Common Law Factors -- Complete Text (1987-1 CB 296). You should consult a legal or tax advisor for advice concerning specific questions and situations. An excellent and informative summary of legal issues related to the hiring of independent contractors may be found in Independent Contractors: A Manager's Guide and Audit Reference, published by the California Chamber of Commerce, P.O. Box 1736, Sacramento, CA 95812-1736, (916) 444-6670. Another excellent resource is Hiring Independent Contractors: The Employer's Legal Guide (1997) by Stephen Fishman, published by Nolo Press. An in-depth and comprehensive discussion of employee vs. independent contractor legal issues is available on-line at Fenwick & West: Publications.
In 1996 the IRS issued a new training manual for its auditors that clarifies somewhat the distinction between employee and independent contractor. The manual advocates a less adversarial approach to classifying workers, and acknowledges that hiring an independent contractor instead of an employee "can be a valid and appropriate business choice". Guidelines in the IRS training manual are more permissive than the original twenty common law factors. The IRS training manual would seem to permit independent contractors to be paid by the hour, participate voluntarily in client provided training programs, work for a single client over a long period of time, work on the client's premises, and accept suggestions from the client about how work is to be done.
No single factor or mix of factors is necessarily sufficient to qualify an independent contractor as an employee. However, since any one factor alone can result in a contractor being reclassified as an employee, hiring firms are usually advised to demonstrate lack of control for all twenty common law factors. The severe consequences of "losing" in an IRS or EDD audit, coupled with a highly unpredictable appeals process, makes it imperative that all parties play it extremely safe.
The twenty common law factors, even when modified by guidelines in the new IRS training manual, place severe limitations on how clients interact with their contract workers. Most companies deal with this issue by disconnecting as much as possible from their contractors' work. The result for contractors is freedom and greatly reduced levels of stress. It is this freedom (as well as the money) that is so attractive to contract workers.
|Contract Employment Agencies as Insurance|
The preceding discussion addresses primarily the subject of independent contractors, and NOT contract employees. Nevertheless, the issues related to the hiring of independent contractors directly impact the working environment of contract employees. Indeed, the issues related to the hiring of independent contractors are largely, if not wholly, responsible for creating the entire industry of contract employment agencies.
Hiring firms are at risk from the IRS and other agencies whenever they employ independent contractors. One mistake by the hiring firm or its employees, and an independent contractor can be converted into an employee. The IRS now investigates the status of independent contractors in all business audits they conduct. And the burden of proof is always on the hiring firm to demonstrate unequivocally that an independent contractor is NOT their employee.
If the matter goes to court, and the hiring firm wins, the legal cost of successfully defending itself can be huge. If the hiring firm loses, the cost is greater still. It is not surprising that hiring firms seek to protect themselves from legal attack by scrupulously heeding the twenty common law factors. The twenty common law factors address the two defining characteristics of independent contractors:
Nevertheless, it is difficult to abstain completely from exercising control over workers. And, frequently some level of control is essential to the success of a project, especially if the project is not well defined, if workers are expected to use company resources, and when the project requires a team effort. One solution is to hire an outside consulting firm. A more frequent solution is to use the services of a contract employment agency. The contract employment agency hires the workers, and withholds all applicable State and Federal taxes, Social Security, unemployment, and disability premiums. Then they "lease" the workers to their client under the terms of a formal contract. This practice addresses the major concerns of the IRS, EDD and other government agencies, namely that taxes are paid and workers receive their government benefits.
Also, when workers are employed by a contract employment agency there is little question that they are, indeed, bona fide employees, and not independent contractors. Hence the term, contract employee. Some companies also require that independent contractors use an employer of record, such as a pass through agency or employment broker. An employer of record, acting as an intermediary, bills the client and handles the paperwork, thus converting the independent contractor into a contract employee. The employer of record then has the option of treating the worker as a bonafide employee by withholding taxes and issuing a W-2 form, or of treating the worker as an independent contractor. In either case, from the client's perspective the worker is a "contract employee".
We must note, however, that an employer of record who pays a "contract employee" as an independent contractor places the client company at risk when the IRS conducts their next audit. If the IRS catches the disparity, and the the contractor fails to satisfy the twenty common law factors, the IRS can evoke the co-employment rule, reclassify the independent contractor as an employee of the client, and go after the deeper pockets of the client company.
Contract employment agencies offer the protection that businesses need to avoid problems with the IRS. But there are chinks in the armor. Because most companies offer their employees more and better benefits than do the contract employment agencies, it can still be argued that some client companies use contract employees to avoid paying benefits. To counter this claim, companies may impose an arbitrary upper limit on the length of individual assignments. This practice is aimed at stemming the possibility that a contract employee will convert by default to one of the client's employees simply by virtue of having worked so long under its direction and control.
There is another, subtle issue that absolutely colors the entire relationship between a client company and its contract employees. It all comes down to this question: How can corporate managers be expected to know which contractors are independent contractors, and which are contract employees, and then treat each appropriately according to the twenty common law factors? The answer is they can't. Consequently, the safest approach is to treat all contractors as if they were independent contractors. Because of this ambiguity, contract employees often experience the two-sided coin of exceptional freedom to do one's work with minimal interference, while receiving little or no support from the client's own employees.
As you can see from the foregoing discussion, contract employment agencies provide insurance against the risk that the IRS and other government agencies will reclassify independent contractors as employees. The impact on contract employees is profound.
|Should You Incorporate?|
Typically, the independent contractor who operates as a sole proprietorship is paid by the client's payroll department on a 1099 basis. If the independent contractor is represented by a partnership, limited liability company, or corporation, the independent contractor is paid as any other vendor on an accounts payable basis.
Consider the following employment options. As a contract worker you are either:
A principle advantage of being self-employed is being able to deduct business expenses when calculating one's personal income taxes. The business expenses of a sole proprietorship are itemized on Schedule C, and filed with the owner's annual tax returns.
Limited Liability Company
The C corporation is the default form of corporation. In this type of corporation earnings are taxed twice; first at the corporate level, and then again when they are distributed as salaries and dividends. The S corporation avoids this double taxation by passing all income through to the shareholders without incurring taxes at the corporate level. For this reason, most incorporated independent contractors are S corporations. S corporations are limited compared with C corporations in the types of business deductions they can claim. Still, S corporations allow significantly more deductions than do sole proprietorships.
If you are considering incorporation, you will definitely want to consult with an accountant, and possibly an attorney, to make sure you do it right. You will need an accurate accounting system, and good advice on what records you should keep. It is essential that you get advice from professionals who have worked extensively with independent contractors, preferably in your area of expertise. Ask your fellow contractors for referrals, and interview several professionals before you make a selection. The price of a good accounting professional will be repaid many times over by the taxes you save and the penalties you avoid.
Yes, many independent contractors are incorporated. But don't incorporate simply because you want to become an independent contractor. In fact, unless your clients require that you be incorporated, or you already have a thriving consulting business, it is probably unnecessary, even unwise, to incorporate at all. Many clients are just as happy working with a sole proprietor as with a corporation.
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Copyright © 1997 by
Jerzy Technical Services
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Last Update: 09/17/97