03 Apr Simple Rules for Hiring Independent Contractors
Business owners routinely hire an independent contractor (“IC”) to perform one-off tasks such as website development, or to handle the more routine affairs for their company such as quarterly bookkeeping. While these relationships are common practice, businesses must be very careful to ensure that their use of an IC is not deemed an “employment relationship” by the IRS or state tax authorities. Such a finding would open your business to significant risk and financial penalties.
To avoid these penalties, it’s critical to ensure that at least one of the following is true when you hire an IC:
1) The IC should do business as a company (LLC or Corporation) and not merely as a sole proprietor.
Ask your IC if they do business through a limited liability company (LLC), a Corporation or any other type of business entity. A best practice for you is to insist on signing contracts only with an IC who has established a company themselves and is not acting in an individual capacity (i.e. as a “sole proprietor”).
Yes, this raises the cost of doing business for the IC, because they may have to form a company just to do business with you. But the reality is that states and the IRS are increasingly looking at this issue and cracking down on violators. (We’ve worked with several businesses facing fines for improper classification for exactly this reason. Authorities are taking the per se position that since the ICs were unincorporated, they were employees of the company – meaning that the “employer” company was assessed with tax penalties long after retaining them). There are a few ways to make this an easy conversation with your IC. Explain that they will see quite a few benefits from forming a company anyway: usually significant tax advantages (their accountant can walk them through the details), and protection of their personal assets from normal business risks. And point out that since tax authorities are increasingly penalizing companies that hire un-incorporated freelancers, the IC will likely be able to get more contracts if they do business as a company.
Note that you should not offer to pay for the IC’s cost of forming their company. But this will be one of the least expensive investments your IC will ever make — any local business law firm can set up their company in a few days and without breaking the bank. If you’re talking to an IC that is not currently organized as a company, it’s no cause for alarm or significant delay — you can simply pause the conversation briefly while they have an attorney form their company, and you can resume it as little as a few days later. You can even continue to write up your agreement with the IC, which usually takes a few days anyway, while their lawyer is forming the company.
2) Ensure that the IC is, in fact, working simultaneously for multiple companies, not just for your company.
This can be difficult to vet, and it can obviously fluctuate throughout your relationship with the IC. Many business owners believe that having a signed contractor agreement that includes a non-exclusivity clause giving the IC the option to work for other companies is sufficient – it is not! The tax agencies often ask whether the IC is, in fact, working for several different companies. Merely giving your IC the option to work for other companies isn’t good enough on its own! If you’re not sure whether your IC works for other companies, it’s critical to insist that the IC form their own company (likely an LLC or S-Corp).
Ideally, both of the above will be true: your IC is a company and you are not its only client. But at a minimum, you will want at least one to be true, or there’s a strong possibility that a tax authority will penalize you for improperly classifying this “employee” as a contractor.
There are of course many other factors to consider in any IC relationship — for example, you will want to ensure (and say clearly in your IC’s contract) that the IC has discretion to make judgment calls in performing its work. But the two issues described above are two of the clearest bright-line rules that we see tax authorities focusing on.