If you need additional personnel for your business but decide your business can't afford to hire any more full-time employees, you might consider using the services of an independent contractor. With an independent contractor, you may save money because you don't have to withhold and pay the person's income, Social Security and Medicare taxes.
And while independent contractors do translate to lower payroll costs, be advised that the IRS scrutinizes this whole area very carefully. The IRS wants to make sure that your workers are properly classified and paying the government the necessary income and payroll taxes that are due.
To stay out of hot water with the IRS, be sure the workers you classify as independent contractors meet the IRS definition of an independent contractor. The IRS has a 20-point text its auditors use to determine the proper classification. Here's a list of the some of the major points:
- Who has control? A worker is an employee if the person for whom he works has the right to direct and control him concerning when and where to do the work. The employer need not actually exercise control; it is sufficient that he has the right to do so.
- Right to fire. An employee can be fired by an employer. An independent contractor cannot be fired so long as he or she produces a result that meets the specifications of the contract.
- Training. An employee may be trained to perform services in a particular manner. However, independent contractors ordinarily use their own methods and receive no training from the employer.
- Set hours of work. Workers for whom you set specific hours of work are more likely to be employees. Independent contractors, on the other hand, usually establish their own work hours.
To stay on the right side of the IRS, it's best to document the relationship you have with any independent contractors in a written contract. This can be a simple agreement that spells out the duties of the independent contractor. The agreement should state that the independent contractor, not the employer, is responsible for withholding any necessary taxes. In addition, have the independent contractor submit invoices. Also, be sure you file Form 1099-MISC (Miscellaneous Income) at year-end. By law, you're required to file and give someone Form 1099 if you pay that person more than $600 a year. The form must be given to the independent contractor by January 31 of the following year. Form 1099 with its transmittal Form 1096 must be filed with the IRS by February 28 of the following year.
If the IRS finds you've misclassified an employee as an independent contractor, you'll pay a percentage of income taxes that should have been withheld on the employee's wages and be liable for your share of the FICA and unemployment taxes, plus penalties and interest. Even worse, if the IRS determines your misclassification was "willful," you could owe the IRS the full amount of income tax that should have been withheld (with an adjustment if the employee has paid or pays part of the tax), the full amount of both the employer's and employee's share of FICA taxes (possibly with an offset if the employee paid self-employment taxes), plus interest and penalties.