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5 Hiring Practices to Keep You Out of Hot Water With the IRS Distinguishing between independent contractors and employees properly means covering all your bases. Here are five important steps to take.

By Barbara Weltman Edited by Dan Bova

Opinions expressed by Entrepreneur contributors are their own.

John R. Coughlin/CNN Money

If you need more help for your business, should you hire new employees or engage independent contractors? The decision will be based on the nature of the work, your business culture, what you can afford and perhaps, most importantly, government rules.

For the IRS, the question of worker classification -- as an employee or independent contractor -- is high on its audit list. States also scrutinize worker classification when claims are made by workers for unemployment compensation and workers' compensation. If you decide that independent contractors better suit your needs than employees, make sure your treatment of these workers will be respected by the government.

1. Check both IRS and state rules.
You can't arbitrarily put the label of independent contractor on a worker and make it stick. It has to be appropriate, based on the degree of control you exercise over the worker. Boiling this down, if you have the right to say when, where and how the work gets done, likely the worker is your employee.

No one factor is determinative. The IRS uses 20 factors that fall into three categories -- behavioral control, financial control and the relationship of the parties -- to determine this. Familiarize yourself with them.

To complicate things, states don't necessarily agree with IRS classification. A worker may be treated as an independent contractor for federal employment tax purposes but an employee for purposes of state unemployment benefits or workers' compensation. Check with your state to learn its rules.

2. Use a written agreement.
One of the factors used by the IRS for determining worker classification is the intention of the parties. You can spell this out by using a written agreement with an independent contractor. The agreement can state that the worker understands he or she is not an employee and is personally responsible for taxes, insurance and other expenses. The fact that there may be reimbursement to the worker for certain expenses, such as travel, won't nix the relationship spelled out in the agreement.

But understand that while this agreement is certainly helpful, it is not binding on the IRS or other government agencies. The government does not have to follow the classification created by the agreement because it is not a party to the agreement.

3. Issue Form 1099-MISC.
If you pay $600 or more to an independent contractor during the year (not necessarily all at one time), you should send IRS Form 1099-MISC to report the annual payments. When doing this, one copy goes to the worker and another to the IRS. Doing this is another indication that you view the worker as an independent contractor. It is also essential for obtaining penalty relief, which I detail below, if it is ultimately determined that the worker is really an employee.

4. Know your industry practices.
If there is a long-standing practice in your industry in treating certain workers as independent contractors, you probably can follow suit. The practice exists if at least 25 percent of your industry follows it.

If you follow long-standing industry practices (and issued a 1099 where required), even if the IRS successfully reclassifies your worker as an employee, you can minimize employment tax penalties by using Sec. 350 relief. This relief is not a section in the Tax Code; it's the section in a 1978 law that created it.

5. Be consistent.
You should treat workers who are performing the same work in the same way. You can't treat some as employees and others as independent contractors. And you can't change treatment from year to year. Stay consistent.

Again, consistency will help you in securing Sec. 530 relief if you need it.

If you still have questions, talk with a tax advisor or employment law expert. Don't wait until the government challenges you. Get your worker classification right from the start so you can secure independent contractor status for workers if that's your aim.

Barbara Weltman

Small Business Expert and Author, Small Business Advisor, Business Consultant

Barbara Weltman is president of Big Ideas for Small Business, Inc., a company that provides tax, financial, and legal information. She’s also the author of numerous books, including the most recent J.K. Lasser’s Small Business Taxes 2014 (Wiley 2013). She blogs at BarbaraWeltman.com/blog.

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