By Mary Dunlap, CFP®, and Debra M. Girvin
In tough economic times, businesses look for ways to be more efficient and profitable. For financial planning practices, that may mean taking a closer look at hiring an independent contractor or hiring an employee. Both situations have pros and cons, and financial planners are often looking for guidance on making the best hiring decision.
Understanding how the Internal Revenue Service and state regulators classify independent contractors and employees will help you determine who to hire so you don't waste thousands of dollars, end up dissatisfied, deliver poor results to clients or risk government penalties from audits.
Government audits are no joke. States routinely check employment records, inquiring about whether a worker is functioning as an independent contractor or an employee. Often times, invoices and other records must be produced to justify an employee's status. What's the probability you will get audited? Who knows? What is the probability you will have a lot of work and worry putting records together for an audit? How about 100 percent! That's why it pays to be prepared from the get-go.
Weighing the Pros and Cons
For many small business owners, powerful motivations exist for hiring independent contractors.
Assuming you found the right contractor who can deliver what you need, you won't be training or developing this person. You also won't pay for benefits, including health and disability insurance, vacation time, sick days and retirement plans-benefits that can cost anywhere from 20 percent to 40 percent of a person's salary.
By hiring an independent contractor, you also won't pay the employers' share of Social Security and Medicare taxes, which are 7.65 percent of compensation, and you won't contribute to state and federal unemployment insurance funds, which can be 2 percent or more of compensation depending on the state.
Independent contractors are not subject to many laws designed for employees, including overtime and minimum wage requirements. By hiring an independent contractor, you won't be subject to complaints for wrongful termination.
While it seems that you may not be liable for an independent contractor's actions, you do have a fiduciary responsibility to hire an independent contractor to complete work in an ethical, legal and compliant manner.
You should also consider the potential downsides of hiring an independent contractor. In general, using an independent contractor assures less control of the process and the resulting end product to you, the business owner, and more control to the independent contractor. And using an independent contractor may not always provide a significant cost savings versus hiring an employee when you consider the higher fees a contractor may charge to do a specific job.
Also, you may not get possession of intellectual property that is generated as a result of the work. For example, programs, spreadsheets or documents could remain property of the independent contractor, and he or she could charge you for use of the materials.
You may find that you want and need to control the process and the people, and not just pay for the results. In that event, you may be better served by hiring an employee.
Keep in mind that you can hire an independent contractor, and then bring that person on as an employee later, as your business needs change. However, you should consult with an expert on how to do this successfully.
Defining Independent Contractors
Hiring an independent contractor should not be done lightly. Many business owners assume that someone qualifies as an independent contractor if the person has what he or she calls their own business and does work for other firms, can bill for their services and can work independently.
However, the definition of an independent contractor is not that simple.
Here is a general list of what federal and state agencies such as the IRS, state revenue departments, and state and federal unemployment agencies look at when classifying workers as independent contractors. This list does not detail everything; you should consult an attorney and human resource expert for more guidance in your specific situation.
- You cannot tell an independent contractor when to do the work and how to do the work, unless it is detailed in the signed contract (agreement) between you and the independent contractor.
- You cannot train the independent contractor unless it is part of the agreement. Training should only be for highly specialized or technical work.
Working on the employer premises
- Independent contractors generally can work wherever they choose. However, working on the employer's premises may indicate a measure of control the firm can exercise over the person, indicating that the contractor is more like an "employee."
- In some situations, independent contractors may need to work on the employer's premises because it could be inappropriate to work elsewhere. Again, these details should be listed in the agreement.
- Tip: Have independent contractors sign a solid confidentiality and non-disclosure agreement so proprietary information does not leave with the contractor.
Working for other firms and having an established business
- Independent contractors should have a work history and they should continue to work for other firms. They should have marketing materials such as brochures or Web sites available to the public to indicate they are offering their services to other firms.
- Independent contractors are responsible for their financial results, producing profits and/or suffering the results of losses.
Agreements and payments
- You should have a signed agreement with an independent contractor; an agreement the contractor has drawn up and with which you agree. This agreement should state the scope of work, fees and other information.
- Independent contractors are responsible for billing you by invoice. They should have a federal or employer tax ID number.
- If a contractor performs more than $600 of work, you must issue a 1099-MISC and should have the contractor's W-9 on file.
Having and furnishing equipment and materials
Independent contractors are responsible for the materials and equipment to get your work done. The more an independent contractor works on your equipment and uses your materials, the more it shows a lack of investment the contractor has in his or her own business-more signs of an employee status. This is not to say that an independent contractor cannot work on your equipment. For example, a computer consulting firm needs to work on your computers, but it is obvious that a legitimate firm has its own equipment and office(s).
Ending the relationship
- Generally, independent contractors and their clients end their relationships when the job is complete. However, you should have a way to terminate the relationship before finishing the work, and this should be included in the agreement.
- In contrast, an employee generally has a longer, continual relationship. However, an employee can be terminated by an employer at any time, provided you are following established guidelines to avoid wrongful termination lawsuits.
- Independent contractors may use or hire others to perform the work involved in the agreement, and this should be outlined in the agreement.
- Independent contractors can decide when and how much time is needed to complete the work. You can, however, give the contractor a deadline.
What Happens if You Classify the Worker Incorrectly?
Incorrectly classifying a worker can lead to a variety of penalties, ranging from 15 percent to more than 40 percent of worker compensation for the effective time period. You could also incur penalties for not collecting Social Security payments.
The IRS also looks to see if you intentionally misclassified workers to avoid certain levels of compensation from being considered in retirement plan contributions. As a result, your retirement plan could lose its tax qualified status.
Overall, to be sure you make the right kind of hire-either an independent contractor or an employee-assess what you need in terms of control, training and length of job. And when hiring an independent contractor, always keep good records of work agreements and invoices.
Mary Dunlap, CFPÒ, of Mary Dunlap Consulting, helps financial planning firms attract, develop and retain the best people for their teams.
Debra M. Girvin, SPHR, has worked in human resources and benefits management since 1985. She and Mary Dunlap are members of the Society for Human Resource Management. Contact Mary and Debra at email@example.com.
What's Best for You?
Here are some considerations for deciding if you should hire an independent contractor or an employee:
Length of project
Is this an ongoing project requiring continual work with no definitive end date? You may need to hire an employee unless this work requires high skills, knowledge and no direction from you.
If you are only interested in the results and prefer the person has independence as to how the work gets done, you should hire an independent contractor.
You could require an independent contractor use certain scripts when contacting people and also require the contractor to enter information into specific software in a specific manner. However, you cannot tell the contractor when to do the work; you are paying for results within an agreed upon time frame.
Relationships with clients and team members
If the work that you need done requires continuous contact and relationships with clients and team members, you should hire an employee.
If you want to train someone to follow prescribed methods, communication standards, etc., you have to hire this person as an employee.
Integration with the business
If any of these apply, you need to classify the worker as an employee:
- The person has limited risk in losing money
- The person works only with you and not others in the general public
- You mention this person in your client marketing materials, directly or indirectly describing them as an employee and not an independent consultant.
Commissioned sales people
Consult an expert to determine how people you hire to build business and/or meet with clients are classified according to payment of taxes and contributions.
Companies that offer virtual assistants should be treated in the same manner as companies offering temporary employment. Virtual assistants can offer their services on their own. You should consult an expert on how to classify this person an employee or independent contractor.