When your business is just starting out, it may make more sense to hire independent contractors instead of employees. You don’t have to worry about paying half of their employment taxes, and you don’t have to cover them with Workers’ Comp Insurance, either. Still, you get the help you need, and your contractor gets a gig. Sounds like a win-win, right?
Not exactly. Turns out, the line between an employee and an independent contractor isn’t always so clear. You may think you’re following all the rules, while the contractor thinks they are being treated like an employee without the benefits.
At least that’s what happened to Tya Bolton, chief executive of Exceptional Business Solutions. She recently shared her small business’s worker misclassification dilemma in an article with The Washington Post. Bolton thought she did her research on what constitutes an employee versus an independent contractor. Then she faced an audit from the Maryland Department of Labor, Licensing, and Regulation. One of her independent contractors filed for unemployment benefits after a long-term project ended.
Bolton had to submit the work and compensation history for not only that independent contractor, but records on every person she hired in the past three years. After reviewing materials, the DLLR determined the past contractor was an employee, as well as three others. As a result, Bolton had to pay thousands of dollars in employment taxes.
The moral of the story? Your small business may owe unexpected expenses (e.g., employment taxes, unpaid overtime, benefits, and more) to independent contractors, even years after working with them. Let’s find out how you can avoid such a debacle.
Drawing Lines: How to Tell If Your Independent Contractor Is Really an Employee
A worker is usually an independent contractor if they work independently, are paid on a per-project basis, use their own tools, and don’t receive benefits. But it’s not always that simple.
While there are general criteria to follow, there’s no black and white definition to distinguish a contractor from an employee. Employment lawsuits are typically decided on a case-by-case basis. Small businesses and workers can file Form SS-8 with the IRS to request a determination of worker status when considering employment taxes and income tax withholding.
The IRS uses three categories to classify workers: behavioral control, financial control, and relationship of the parties involved. To ensure you’re properly identifying your contractors, Bolton suggests asking questions such as…
- Does your contractor do similar work for others and identify that on their tax forms?
- Does the contractor have a website?
- Has the contractor provided you with a complete W-9 tax form?
- Are you giving the contractor control to handle tasks with little direction from you?
If the answers to these questions are “yes,” then you may well have an independent contractor on your hands. You run into trouble when you are a contractor’s only source of revenue and they can’t control the manner in which they complete their work.
If you’re not sure how to classify your workers, ask someone who does. You can call the IRS with questions, consult your state’s guidelines, and seek guidance from a legal professional. For help getting started, check out the Internal Revenue Service’s 20 factor checklist.
Do You Need to Insure Your Independent Contractors?
Improper worker classification can cost you big time, but that’s just the start. If your contractor is really an employee, you may need to purchase Workers' Compensation Insurance. Most states require employers to carry Workers’ Comp coverage once they hire employees. A Workman’s Comp policy can help your business pay for employee occupational injuries.
If your contractor is properly classified, you may need to add them to your General Liability Insurance policy as an additional insured for the duration of a project. That way, your business can be financially protected if it’s sued for mistakes your contractor makes.
Alternatively, you can require independent contractors to have their own General Liability coverage. But in most cases, they should have their own or Workman’s Comp Insurance, especially if they work in the construction industry. You can check their Certificate of Liability Insurance for proof of these coverages.