Taxes · November 18, 2021

What Are Independent Contractors? Everything You Should Know

Businesses often save money by using independent contractors instead of employees. However, the IRS and the Department of Labor, or DOL, are cracking down on large employers that they believe misclassify employees as contractors, collecting taxes that may have gone unpaid due to the misclassification.

Although smaller employers are less likely to be affected by DOL and IRS enforcement, there's still some risk they could unknowingly violate these rules. Business owners can protect themselves and their companies by fully understanding the differences between independent contractors and employees, then complying accordingly.

Differences between independent contractors and employees

There are some main differences between employees and contractors. Employees receive specific benefits and protections mandated by law, including unemployment insurance, family leave and regular pay periods. They also typically get benefits like health insurance, although these may not always be required by law. An independent contractor manages most of these costs alone, and they're usually only protected by the contract they've signed.

From the government perspective, misclassifying employees leads to losses in payroll tax revenue, as well as fewer funds from unemployment insurance and workers' compensation.

Plaintiff attorneys have begun filing more lawsuits on behalf of people paid as independent contractors. Some of these suits have gained class-action status at large corporations. Firms that have lost the legal challenge have had to pay penalties, as well as back wages and benefits. But the lawsuit risk can be managed with simple documentation and processes.

Who qualifies as an independent contractor?

The IRS only considers someone an independent contractor if the business paying them controls the result of the individual's work, rather than how the work itself gets done. While there's no one-size-fits-all for independent contractor classification, the following are significant determinants:

  • Are projects and assignments negotiated with a written contract?
  • How essential are their services to the business?
  • How long have they been working there?
  • Do they use their own materials and equipment or get reimbursed?
  • Who sets the pay rate, work hours and checks quality?
  • Do they have profit and loss opportunities?
  • How much skill and initiative are involved?
  • Are the workers paying their own self-employment taxes as employer and employee?

If you employ individuals who work as sole proprietors for multiple businesses, create an independent contractor agreement for them to sign. Your contract should make it very clear that the person is serving as an independent contractor by outlining how the relationship will work. To reduce legal expenses, you can modify an existing independent contractor agreement template and review the revision with your attorney.

Filling out the right tax forms for independent contractors

When it's time to file taxes for the year, should independent contractors file a 1099 or something else?

Have all your independent contractors and outsourced service providers complete a W-9, Request for Taxpayer Identification Number and Certification. You can use the W-9 form (PDF) from the IRS website. On the W-9, the individual or firm indicates that they're operating as a business and designates the business type. To ensure contractors return these on time, you might choose to make their completion a condition of receiving payment.

You'll also need W-9s to accurately create and file Form 1099-MISC to report payments your company made to the service providers. This is a tax filing form intended to disclose miscellaneous payments to non-employees throughout the tax year.

During the calendar year, track the payments made to each applicable independent contractor or service provider. If these amounts exceed $600, you'll need to file 1099s. The filing deadline varies from the end of January to the end of March of the following year, depending on what's on the form and whether you file by paper or electronically. A notable exception is that an independent contractor operating as a corporation is exempt, meaning you don't need to file a 1099 for their services.

Taking these steps helps ensure two things. First, it prevents independent contractors from being classified as employees. Second, it provides the IRS and state governments the information they need to collect tax revenue properly. Stay protected and compliant by correctly categorizing independent contractors and employees, creating the necessary documentation and tracking their work accordingly.


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