A small business can save a good deal of money by not having employees. According to the U.S. Department of Commerce, it costs businesses 20-40% more per worker to classify someone as an employee versus an independent contractor. Although calling someone an independent contractor can save a businesses a lot of time and money, the consequences of re-classification by the IRS can be severe if the person is actually acting in the capacity of an employee.

Classifying individuals as non-employees is tricky. It is very risky to directly engage individual contractors who do not have a business license, a state business identification number, their own place of business, their own equipment, and who are solely dependent upon your business for their livelihood.

Hallmarks of an Independent Contractor
Bona fide independent contractors meet the following criteria, among others:

1. They are in business for themselves;
2. They typically have multiple clients;
3. They determine whether they will do the work themselves and/or use employees or subcontractors;
4. They furnish their own tools, equipment and materials; and
5. They pay income and business taxes on business revenues and payroll taxes on employee compensation.

In short, independent contractors should not be working full time at your business, using your equipment and supplies and doing the same work as your employees.

The Risk
The IRS can order offenders to pay all employment taxes that should have been paid plus a penalty that ranges from 12-35% of the tax bill. And that’s just the federal side of the equation. Your state will likely weigh in and take a bite out of you for back state payroll taxes and fees, plus their own penalty for non-compliance.

The Tip
If you are using independent contractors to assist with your business, make sure you are treating them as contractors and not employees. A few things you should do to protect the classification are:

1. Pay them by the job, not the hour;
2. Don’t require all work to be done on your premises;
3. Make sure they have their own business licenses;
4. Have all contractors sign a contract detailing the terms of the relationship.

Contractors come in all shapes and sizes; the ones you hire directly should be bona fide contractors with established business credentials to avoid the risk of re-classification by the IRS.