Hiring Contractors for Your Small Business

Hiring Contractors for Your Small Business
••• kate_sept2004/E+/GettyImages

Hiring workers as subcontractors has a number of benefits for small businesses. With subcontractors, business owners don't have to pay matching Social Security (FICA) employer taxes, pay unemployment taxes, be responsible for withholding federal and state payroll taxes and provide benefits, such as health insurance, retirement plans and paid vacations, which can increase your payroll costs by ​20 to 30 percent.

Therefore, getting this classification between who is an employee and who is a subcontractor right is extremely important. However, get it wrong, and the business could be subject to penalties, fines and interest on unpaid tax liabilities, which can increase your tax bill by ​30 percent​ or more.

Here's what you need to know to determine whether your worker can be treated as a subcontractor or must be considered an employee.

Determining Employee or Self-Employed Status

Determining whether a contractor is an employee or is self-employed is an important distinction that has significant consequences from a tax liability standpoint. The IRS uses these factors to determine the employment status of a subcontractor:

  • Does the worker determine which tasks will be done, how they will be done, where and when?
  • Does the worker send invoices for their services?
  • Does the individual work for other clients?
  • Do the employer and the worker have a written independent contractor agreement?
  • Does the worker provide their own supplies, equipment and workspace needed to perform the services?
  • Are the workers paid by the hour, commission or on a project basis?

If you can answer yes to these questions, then you’re probably justified in hiring the individual as an independent contractor, and you'll be able to avoid the issues that come with hiring employees.

The classification is not determined by any single factor. It is a consideration of all the factors, and the burden of proof is on the employer to make their case. To make the issue more confusing, many states have regulations that are different from the IRS. So the definition of who is an employee or a subcontractor can vary from state to state.

Pros of Independent Contractors

Before you decide to hire an independent contractor, you need to consider the pros and the cons and be sure your classification will meet the criteria of the IRS.

Here are the pros of using independent contractors:

  • Will probably cost you less:​ With independent contractors, you don't have to provide benefits, office space and equipment. You also don’t have to contribute an employer's share of the employee's Social Security and Medicare taxes, which can add up to ​7.65 percent​ of an employee's wages. In addition, you don't have to pay federal and state unemployment compensation insurance or workers’ compensation insurance.
  • Have more flexibility:​ You can hire independent contractors as needed and release them when the job is done. This is particularly beneficial if you have workloads that fluctuate. When the workloads decline, you won't have to deal with the unpleasantness, expense and possible legal issues for wrongful termination that sometimes come with firing and laying off employees.
  • Reduce exposure to lawsuits:​ Federal and state regulations provide employees with a wide range of rights, which gives them the opportunity to file legal claims against employers who violate those rights. These would include lawsuits based on discrimination of race, color, religion, national origin and gender. You also wouldn't have to deal with disputes about paying minimum wages or overtime wages when you enter into a fixed-price agreement with an independent contractor.

Cons of Independent Contractors

Hiring independent contractors has these downsides:

  • Loss of control:​ With employees, you can supervise and manage their activities as much as you want. With independent contractors, you hire them to do a job, and they get to decide how they do it. If you try to micromanage their work, you increase the risk of the independent contractor becoming an employee, which creates the liability of having to withhold payroll taxes and pay for benefits and workers’ compensation.
  • Disruptive workplace:​ Independent contractors are generally free to come and go at their discretion. This can create a work environment that’s disruptive and inconvenient for your employees. If you're more comfortable with having employees work on a consistent schedule, you might be better served with full-time employees rather than independent contractors working on a part-time basis.
  • Liability for injuries:​ Your workers' compensation insurance will protect you and cover medical expenses for your employees who are injured on the job. However, your workers’ compensation does not cover injuries incurred by independent contractors working on your premises. This leaves you open to lawsuits for damages if they can prove their injuries were the result of your carelessness creating an unsafe work environment.
  • Attract government attention:​ State and federal governments want to classify as many people as possible as employees, not independent contractors. Governments can collect more money from employees instead of self-employed workers who may underreport or try to hide their income from the tax authorities. Government agencies are always on the lookout for companies using independent contractors and will conduct an audit if they believe the business is not classifying them correctly.

What About Workers' Compensation?

Every employee should have workers’ compensation coverage to pay for any medical expenses resulting from work-related injuries. This includes individuals who work for an employer and independent contractors.

Each state has its own set of rules regarding what kind of working compensation coverage is required and who should provide it. If a business hires an independent contractor, the business owner must be sure they are in compliance with state regulations.

In any case, business owners should ask for certification from their independent contractors that they have their own workers' comp insurance and also any licenses that are needed to perform the project. Otherwise, the business owner may be leaving themselves open to liability for damages and injuries from work-related accidents.

Filing Form 1099-NEC

If you're a business owner who's wondering where to get the forms for your independent contractors, the IRS makes them easily accessible online. The IRS defines when you must issue a 1099-NEC as follows:

  • You paid a person who was not an employee for services related to your business.
  • The payments to a nonemployee totaled ​$600​ or more during the year.
  • The payments were made to an individual, a corporation or a partnership.

A Form 1099-NEC requires the following information:

  • the legal name of your business, address and employer identification number (EIN)
  • the name of the recipient with address, Social Security number or tax ID
  • the total amount of compensation paid to the recipient in the previous year
  • the amount of any federal income tax withheld
  • any information required the state