Businesses often hire independent contractors (“ICs”) instead of employees. ICs are a useful way to augment a company’s workforce in situations where the business has a defined scope of work to be done over a set period of time. Instead of bringing on an employee (and the responsibilities that go along with it, such as healthcare and retirement obligations), a business can easily scale to accommodate the need for additional help.
ICs work across a variety of business types, ranging from software to transportation. As like most things in life, simply calling your worker an independent contractor does not make it so. You must avoid common pitfalls during the course and scope of the IC’s tenure at your firm, lest the IRS designate that you have an “employment relationship” and take away the punch bowl from your party. This type of finding opens up your business to substantial legal risk.
One critical factor for determining whether someone is an IC is a contract provision that states the IC has sole discretion to make decisions about how the work as performed. In essence, you are stating the “what” and the IC’s job is to figure out the “how.” Uber is an excellent example: get into the car, tell the driver where to go, and she figures out how to get you there. That’s a pure IC. However, this factor is not dispositive for the IRS. Therefore, you must ensure that at least one of the following characteristics is true when you are working with an IC:
Option 1: Don’t Hire People, Hire Companies
In other words, you should only hire ICs who are self-employed through a limited liability company (LLC), a corporation, or a similar business type. As a general rule, you should not hire ICs who are not working in an individual capacity as a sole proprietor.
While this is not legally required, the reason you hire a lawyer is to help you navigate the legal landscape of what’s happening in your industry. The IRS is increasingly cracking down on employers who hire individuals (who you claim to be ICs), finding the absence of a corporate registration as compelling evidence that the person is not who you claim them to be. An improper classification, in the eyes of the IRS, can result not only in substantial fines, but tax penalties that linger well after your IC’s termination date.
We know the approach of asking your IC to form an LLC is an additional time and cost burden that they may not want to do. There is no question that it raises the cost of doing business for the IC and creates additional paperwork for both parties. But like life’s certainties of death and taxes, the suffocating growth of government is quickly becoming a third promise of living in the United States of America.
Fortunately, there are certain benefits you can explain to your IC which will incentivize them to create an LLC. Forming a company will usually give them tax advantages, a way to separate their personal assets from their corporate assets, and the creation of an LLC will make them more attractive to other companies in the future if they are operating solely as a corporation and not as an individual.
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.
Option 2: Verify Simultaneous Employment
If you can prove that an IC is working for multiple companies, you are more likely to prevail in an employment dispute with the IRS because it is common practice for ICs to work for multiple employers at the same time. This is a difficult thing to verify, however; and it factors can change during your relationship with the IC.
Often, businesses think that getting the IC to sign a non-exclusivity clause (which gives ICs the option to work for other companies) is enough to meet this evidentiary burden. Unfortunately, this is not enough. The IRS will usually ask whether the IC is–actually–working for other companies, and will use the evidence gathered to make its tax determination. It is not enough for you to merely allow simultaneous, non-exclusive employment.
This brings us back to Option 1. If you are not able to verify Option 2 (and you probably won’t be), then you should stick to the first option as your best bet.
In Closing
The perfect situation is one where your IC (1) is a company (2) with many simultaneous clients. While it’s unlikely you will be able to establish that both are true, a strong fallback position is verifying that one is true. If you are not able to do this, it is possible that the IRS will unfairly penalize you for labeling the IC as an employee.
Uncle Sam is both benevolent and vindictive. He will punish you for flying blind without the advice and counsel of an experienced attorney. Partnering with ESQx will ensure that everything is done by the book, so you can focus on your business. Get in touch today.
