As your company is primarily fulfilling contracts, it is possible that your workers could be classified as "contractors." There are a number of factors in determining whether a worker should be a "contractor" or an employee.
The benefits of engaging contractors (1099 workers) are that the company doesn’t withhold income taxes, doesn’t withhold and pay Social Security and Medicare taxes and doesn’t pay unemployment taxes on what a contractor earns. Contractors like it because their untaxed checks are greater than what they would receive for the same work if they were employees.
The advantage of hiring employees (W2 workers) is that you will not be challenged by the Internal Revenue Service or other state or federal governing entity about the legal validity of your classifications. Many employers misclassifying employees as contractors face tax audits and lawsuits with potentially significant payouts. This happens because the employer is saving money at the expense of the federal and state governments and at a detriment to the worker as well.
So under federal and state laws, an independent contractor must be just that -- independent. It is very important to make the distinction properly. Contractors should all have specific self-determining kinds of work to do, normally in a finite time period, with defined deliverables, using their own place of work, and so forth. If you look at Section Two of the IRS Publication 15-A, you will see exactly what the IRS considers when determining whether a worker is an employee or an independent contractor (i.e., 1099 worker).
In addition, the IRS will help an organization free of charge to determine the appropriate classification for a worker or group of workers in the organization as regards federal law. To obtain that service, you simply complete and submit IRS Form SS-8 to the IRS. However, your state may have different or additional requirements.
It’s not uncommon for a worker whose contract period has ended to apply for unemployment insurance benefits with a state agency. Then, when officials do not find any earnings reported for the worker, an investigation ensues. For misclassifications, the payouts most often involve benefits, lost wages including unpaid overtime and significant penalties as well.
There have been sizable awards for very high-profile companies such as Microsoft and Time-Warner/AOL due to misclassifications of employees as contractors. So you may want to consider that the potential pitfalls of retaining independent contractors can outweigh the short-term savings in benefits and reduced paperwork for some firms. On the other hand, if the people you are engaging do meet the criteria of the IRS regarding independent contractors, you have well-crafted professional services agreements in place with each one and you are careful in administering their contributions and status, you will be fine.