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Contractor FAQ

Independent Contractor FAQ

What is an independent contractor?

Independent contractors (ICs) are people who are in business for themselves. Independent contractors earn their livelihoods from their own independent businesses instead of depending upon an employer to earn a living. Independent contractors are sometimes called consultants, freelancers, the self-employed and even entrepreneurs and business owners.

What are the benefits of being self-employed?

You are your own boss. When you're self-employed, you are your own boss, with all the risks and rewards that entails. You decide whom to work for, when to work and how to do your job. Many self- employed people report that the increased freedom they enjoy is the greatest benefit of self- employment.

You may be paid more than employees.

According to The Wall Street Journal, independent contractors are usually paid at least 20% to 40% more per hour than employees performing the same work. Hiring firms can afford to pay ICs more because they don't have to pay half of the ICs' Social Security taxes, pay unemployment compensation taxes, provide workers' compensation coverage or provide employee benefits like health insurance and sick leave. All these items add at least 20% to 30% to employer payroll costs. Self-employed people are supposed to pay for these things out of their own pockets -- and they can only afford to do this if they get paid more.

Of course, exactly how much you're paid is a matter for negotiation between you and your customers. Independent contractors whose skills are in great demand may receive far more than employees doing similar work.

No federal or state tax is withheld.

Another advantage of being self-employed is that no federal or state taxes are withheld from your paychecks as they must be for employees. Instead, independent contractors normally pay estimated taxes directly to the IRS four times a year. This means you can hold on to your hard-earned money longer before you have to turn it over to the IRS. Moreover, if you're self-employed, it's up to you to decide how much estimated tax to pay (but there are penalties if you underpay). This means you have more control over your cash flow than employees do. But, be sure to keep track of your Net Income so you are making proper tax deposits. Non-compliance in this area can be very costly.

Independent Contractors receive a Form 1099 from their customers. Form 1099 is required to be submitted to the IRS for payments over $600 per year to individuals, partnerships and other unincorporated entities. There is no Form 1099 filed for payments to a Corporation.

Increased business deductions

. Finally, when you're in business for yourself, you can take many tax deductions that are limited or not available at all for employees. As a self-employed person, you can deduct from your income tax any necessary expenses related to your business, as long as they are reasonable in amount and ordinarily incurred by businesses of your type. For example, you can generally deduct office rent and other expenses, including those for home offices, travel expenses, entertainment and meal expenses (subject to limitations), equipment and insurance costs and more. In contrast, an employee's work- related deductions are severely limited. See the section on Independent Contractor deductions for more specific information on types of allowable deductions.

What are the drawbacks of being self-employed?

Despite the advantages, being self-employed is no bed of roses. Here are some of the major drawbacks.

No job security.

When you're an employee, you must be paid as long as you have your job, even if your employer's business is slow. This is not the case when you're self-employed. If you don't have business, you don't make any money.

You must pay self employment taxes.

Unlike employees who have half of their Social Security and Medicare taxes paid by their employers, self-employed people must pay their own Social Security and Medicare taxes. These are called self- employment taxes. The self-employment tax rate is 12.4% of an IC's earnings up to the taxable limit for Social Security, and a 2.9% Medicare tax on all IC income. In 2009 through 2011 the taxable limit on social security is $106,800.

No employer-provided benefits.

Although it is not required by law, employers usually provide their employees with health insurance, paid vacations and paid sick leave. More generous employers may also provide retirement benefits, bonuses and even employee profit sharing.

When you're self-employed, you get no such benefits. You must pay for your own health insurance, often at much higher rates than those that employers pay. Time lost due to vacations and illness comes directly out of your bottom line. And you must fund your own retirement.

No unemployment insurance benefits.

The self-employed also don't have the safety net provided by unemployment insurance. Hiring firms do not pay unemployment compensation taxes for the self-employed, which means that ICs can't collect unemployment when their work for a client ends.

No employer-provided workers' compensation.

Employers must generally provide workers' compensation coverage for their employees. If you're an employee and are injured on the job, you're entitled to collect workers' compensation benefits even if the injury was your fault. Hiring firms do not provide workers' compensation coverage for the self- employed. If a work-related injury is a self-employed person's fault, he or she has no recourse against the hiring firm.

Few or no labor law protections.

A vast array of federal and state laws protect employees from unfair exploitation and discrimination by employers. For example, federal law protects workers who wish to unionize, protects employees from discrimination and requires many workers to be paid time and a half for overtime work. Most of these laws don't apply to the self-employed.

You might not get paid.

If you're an employee, your employer must pay you even if its clients or customers fail to pay it. This is not the case when you're self-employed. You bear the risk of loss from customers in financial distress or those that declare bankruptcy. Many self-employed people have horror stories about clients who refused to pay them.

You may be personally liable for business debts.

Finally, if you're a sole proprietor or partner in a partnership, you are personally liable for your business debts. Employees are not liable for the debts incurred by their employers. An employee will lose his or her job when the employer's business fails, but will owe nothing to the employer's creditors. An IC whose business fails could lose everything he or she owns. So, it is very important to decide the form business organization to minimize risks to yourself and family.

How do government agencies determine whether a worker is an employee or an independent contractor?

There is no single, clear-cut test for classifying workers as employees or independent contractors. Different legal tests for determining worker status are used by various government agencies, including:

  • the Internal Revenue Service
  • state unemployment compensation insurance agencies
  • state workers' compensation insurance agencies
  • state tax departments
  • the United States Labor Department, and
  • the National Labor Relations Board.

Each of these agencies is concerned with worker classification for different reasons, and has different biases and practices. Each agency normally makes classification decisions on its own and doesn't have to consider what other agencies have done, which means that one agency might decide that you are an independent contractor while another classifies you as an employee. It's also possible, though rare, for a worker to be deemed an independent contractor in one state and an employee in another.

How does the IRS decide whether to classify a worker as an employee or an independent contractor?

The IRS uses the common-law "right of control" test to determine worker status. Under this test, workers are employees if the people they work for have the right to direct and control the way they work -- including the details of when, where and how the job is accomplished.

In contrast, independent contractors are not controlled by the firms that hire them. A hiring firm's control is limited to accepting or rejecting the final results that an independent contractor achieves.

The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor. The agency is more likely to classify as an independent contractor a worker who:

  • can earn a profit or suffer a loss from the activity
  • furnishes the tools and materials needed to do the work
  • is paid by the job
  • works for more than one firm at a time
  • invests in equipment and facilities
  • pays his or her own business and traveling expenses
  • hires and pays assistants, and
  • sets his or her own working hours.

The IRS is less likely to audit an Independent Contractor doing business as a Corporation. The reason is the IRS wants to audit a "payor" Company that it can reclassify workers as employees. This way, they IRS can collect taxes quicker ans assess penalties and interest. A Corporation by definition, cannot be an employee. Add, the fact that no Form 1099 appears on the IRS computer system next to the Independent Contractor's name, keeps them from being included in random IC audits.

On the other hand, the IRS is more likely to classify as an employee a worker who:

  • can be fired at any time by the hiring firm
  • is paid by the hour
  • receives instructions from the hiring firm
  • receives training from the hiring firm
  • works full-time for the hiring firm
  • receives employee benefits
  • has the right to quit without incurring liability, and
  • provides services that are an integral part of the hiring firm's day-to-day operations.

How do agencies other than the IRS decide whether a worker is an employee or an independent contractor?

State workers' compensation, unemployment compensation and tax agencies use various tests to determine worker status. Many use the common-law right of control test, but emphasize different factors than the IRS. Some use an economic reality test that focuses on whether a worker is economically dependent upon the hiring firm -- this means that those who work for more than one firm at once are more likely to be classified as ICs..

Many state unemployment compensation agencies use a special statutory test, also called the ABC test.

This test focuses on just a few factors:

  • whether the hiring firm controls the worker on the job
  • whether the worker is operating an independent business, and
  • where the work is performed -- that is, whether the hiring firm or the workers gets to decide
where the work gets done.

What happens if the IRS or another government agency decides that I should have been classified as an employee?

Initially, it's up to you and each hiring firm you deal with to decide whether you should be classified as an independent contractor or an employee. But this decision is subject to review by various government agencies, including the IRS and state workers' compensation and unemployment compensation agencies. These agencies are constantly on the lookout for hiring firms that, in their view, misclassify employees as independent contractors. For a good reason: they stand to collect more money sooner if you are classified as an employee.

If one or more of these agencies determine that you should have been classified as an employee, both you and the hiring firm can suffer severe -- but very different -- consequences. For example, if the IRS audits a hiring firm and determines that you should have been classified as an employee instead of an independent contractor, it will impose substantial assessments and penalties on the firm. At the very least, the firm will have to pay 20% of the FICA taxes that should have been withheld from your pay, 100% of the FICA and federal unemployment taxes the employer should have paid, a penalty equal to 1.5% of your compensation, interest and sometimes other hefty penalties as well.

You won't have to pay any IRS penalties or assessments. But you might lose certain business deductions that aren't available to employees.

Audits by state workers' compensation, unemployment compensation and tax agencies can also result in assessments and penalties being imposed against the hiring firm, but not against you. Even though it is the employer -- not you -- who has to pay the penalties imposed by the government for misclassification, you can still suffer greatly if the IRS or other agency determines that a hiring firm should classify you as an employee. For one thing, the firm may dispense with your services because it doesn't want to pay the additional expenses involved in treating you like an employee. Or the hiring firm may insist on reducing your compensation to make up for the extra employee expenses.

Should I use written agreements when I do independent contract work for clients?

Most definitely, YES! Using a written agreement avoids disputes by providing a written description of the services you're supposed to perform, when they are to be performed and how much and when you will be paid.

A written independent contractor agreement can also help establish your independent contractor status. Although an agreement by itself is never enough to make a worker an independent contractor, it will help show the IRS and other agencies that both you and the hiring firm intended to create a hiring firm-independent contractor relationship, not an employer-employee relationship.

IRS training materials state that where all the other factors are evenly balanced, a written client agreement may tip the scale to the independent contractor side. But remember, an independent contractor agreement is only useful if it's obeyed. It will be useless if you act -- and are treated -- like an employee.