Hiring Contractors: Avoiding the Employee Trap

Businesses that hire contract labor should take a few steps to make sure that they are protected from a phenomenon called the "employee trap."

What is this exactly?

It is when a contractor can be reclassified under law as an employee of the company.

This not only completely changes the business relationship but also burdens your company with new responsibilities with regard to that relationship that could prove detrimental to your bottom line.

To avoid the "employee trap," here are six steps businesses should take:

A Written Contract with a Specific Timeframe
When you hire a contractor, you need to have that relationship bound by a contract that stipulates timeframes, payment amounts, schedules, and whether or not the contract can be renewed.

In other words, your contract needs to set specific, tangible limits on the business relationship and both parties need to follow this to the letter.

Project-Based Work
You do not want to hire contractors for open-ended projects or for ad hoc work. Why? For one, this means that the relationship isn’t bound by a specific timeframe with deliverables attached to it.

Second, it means that the contractor, in a sense, is performing regular work for your business - even if it is just the random needed task here and there. All work with a contractor must be project-based assignments with specific goals and deliverables attached to it.

No Micromanagement or Oversight of Contract Labor
If you are providing management and oversight of the contractor's work, then you are, in effect, the contractor's direct report. This makes the contractor closer to an employee than an independent laborer in the eyes of the law.

Companies that want to avoid the "employee trap" should refrain from micromanagement and allow the contractor to perform the needed work according to a combination of best practices and the contractor's own expertise.

Contractors Work for Other Companies
Another key pitfall to avoid with the contractor relationship is that working for your firm cannot limit the contractor’s ability to perform work for other firms. If you want an exclusive relationship with that contractor, then you should consider making them an employee. However, this doesn’t mean that you can’t protect your intellectual property or proprietary knowledge.

No "Employee Benefits" Provided
The main theme of keeping the employee side of things separate from the contractor relationship continues to benefits. Your company cannot provide benefits or remuneration outside of that stipulated in the contract.

Again, you don't want the appearance that the contractor is an employee of your firm. Further, and as we’ve stated multiple times, if you do require the services of a contractor on a consistent basis, then it may make sense to expand your current workforce and hire either the contractor in question or someone with similar skills.

No Training
Hand in hand with the provision that employers provide no project management or oversight of the contractor in question outside of managing the contractual relationship itself is the fact that employing companies cannot offer training to contractors.

Everything You Need to Know About Independent Contractor 1099 Filings

Understanding the rules and regulations surrounding contractor 1099s can be confusing, especially with recent changes by the IRS. The IRS has created strict rules and regulations surrounding the reporting of contractor income. The difference between and employee and a contractor, the filing requirements and penalties are all areas that you will need to be knowledgeable on before you begin filing.

How to Hire a Contractor

Determining whether or not the individual you hire is a contractor or employee is critical to pay them in the proper way. The first step to deciding independent contractor or employee status is to look at the relationship between the company and the worker. According to the IRS, there are three categories to look at: behavioral control, financial control and the relationship. Beginning with behavioral control, analyze whether the candidate has the right to direct and control the work performed. If the individual decides when and where to work, they are most likely an independent contractor. If the candidate receives training or frequent evaluations, they are most likely an employee. Furthermore, financial control is understood by whether the business has control over the financial aspect or not. If the candidate supplies their own equipment, has an opportunity for profit or loss and is paid with a flat fee, the candidate is an independent contractor. However, if the opposite is applied and there is a weekly or biweekly wage paid, the candidate is considered an employee. The last area that should be analyzed is the relationship between the business and candidate. If the task at hand is a one-time project and the services are not a key part of the business, the candidate is an independent contractor. On the contrary, if benefits are provided, like health insurance, and the relationship is for the indefinite future, the candidate should be treated as an employee.

Tax Implications of Employee vs Contractor

There are a few reasons that the IRS is strict on differentiating between an employee and an independent contractor. The first reason is payroll taxes. Regular employees will have payroll taxes withheld. These taxes include employee and employer portions of social security and medicare along with federal and state unemployment. If you hire an independent contractor, you do not need to pay for payroll taxes. Instead, the independent contractor should be paying in these taxes on their individual return. Generally, any amount in box 1 of the 1099-NEC is subject to self-employment taxes by the contractor when they file their taxes at year-end. The IRS closely monitors 1099 and W-2 submissions to crack down on businesses breaking the rules. If you are incorrectly paying an employee as an independent contractor, you could be faced with stiff fines and be liable for missed payroll taxes.

Forms to Obtain

Once you determine that the candidate is an independent contractor, there are a few forms that should be obtained to make tax time a breeze. The first form that should be obtained is a W9. This form includes required information to file the 1099s, like business name, social security number or federal employee identification number and address. All of that information will be included on the 1099, so be sure to ask for it before the contractor begins work. The other form you should ask for is proof of liability insurance. If something goes wrong, you do not want to be liable for any claims. Most independent contractors retain some type of liability insurance as it is required in most states. Keep both of these documents on file to assist you with filing the 1099s at year-end.

New 1099-NEC Form

The IRS released a new form, called the 1099-NEC, beginning in 2020 to separate independent contractor income from other sources of miscellaneous income. NEC stands for non-employee compensation, frequently known as payments to independent contractors. There are reporting guidelines that should be followed when issuing a 1099-NEC as not every contractor will need to receive one. According to the IRS, if the four following conditions are met, you must generally report payments to contractors on a 1099-NEC: you made a payment to someone who is not an employee, you made a payment for services in the ordinary course of your trade or business, you made the payment to an individual, partnership or estate and the payments totaled at least $600. Furthermore, payments made to an attorney should always be reported on a 1099-NEC. If you pay a contractor and the total amount billed during the year is less than $600, no 1099-NEC is required to be issued. Moreover, payments to any incorporated business do not need to be reported on a 1099-NEC. A good way to tell if the business is a corporation is to look at the full legal name. If the legal name includes inc. or incorporated, no 1099-NEC is needed. You are also required to file a 1099-NEC if any federal tax is withheld from the contractor.

How to File

Filing 1099-NECs on time is critical in order to avoid fines and penalties. 1099-NECs are required to be filed by January 31 of each year. The short time frame is necessary so contractors have the forms in time to file their individual returns. If the deadline is not attainable, there is a 30-day extension that can be granted. This can be done through filing Form 8809. The taxpayer identification number and legal name on the 1099-NEC must match what is filed on the individual return. This is because the IRS frequently checks the income submitted on the individual return with what was electronically filed with the state. With new technological advancements, this is often done automatically and with no additional work required by the IRS. If discrepancies exist, the IRS may pull the individual return for audit.

Furthermore, forms can be filed by sending paper copies to certain districts depending on the state you are filing in. However, a majority of 1099-NECs are filed online. E-filing is strongly encouraged by the IRS since the forms contain confidential personal information of the company and contractor. Forms can be electronically filed through the IRS’s Filing Information Returns Electronically System (FIRE System). If you are filing over 250 1099-NECs, you must file electronically. However, if less than 250 are being filed, you have the choice of paper filing or electronically filing. To be eligible for electronic filing, you must file Form 4419 by November 1 of the prior year. The IRS needs ample time to process the Form so at least 45 days before year-end is required. If you need to electronically file and have not submitted Form 4419 by November, you can submit Form 8508 for a waiver to electronically file the form. Once a waiver is approved, you may electronically file the 1099s.

Deadlines, Penalties & Fees

Since the IRS enforces strict deadlines, there are stiff fines and penalties for late filings. If you do not have an approved electronic filing waiver and you continue to file the 1099s, you can be subject to a penalty of $280 per return type. Penalties can be incurred if you fail to file timely, fail to include required information, fail to include correct information, incorrect filing, incorrect identification number and failure to file readable forms if paper filing. The penalty can be $50 per information return if you file within 30 days after the due date, with a maximum penalty of $571,000 per year or $199,590 for small businesses. Moreover, you can get charged a penalty of $110 per information return if you correctly file more than 30 days after the due date but by August 1. The maximum penalty is $1,713,000 or $571,000 for small businesses. Additionally, you can be charged with a $280 penalty per information return if you file after August 1 or do not file the required returns. This penalty comes with a maximum of $3,426,000 or $1,142,000 for small businesses. The IRS has implemented lower penalties for small businesses due to the hardship it can have on the business. To be classified as a small business, you must have average annual gross receipts of less than $5 million for the 3 most recent tax years. Moreover, you can file an exemption from the penalty if you can prove there was a reasonable cause and not willful neglect. You must prove that you acted responsibly and took steps to avoid failure. An error or omission is not considered a failure to include correct information if the return is filed on-time.

Summary

The rules surrounding the reporting of contractor income can be tricky at first, but thankfully the IRS is very detailed about the processes and regulations to follow. Failure to abide by the standards set out by the IRS can result in stiff fines and penalties, making compliance necessary. The last thing you want to do is be stuck with an IRS letter with penalties. Follow the guidelines in this article for initial guidance and visit the IRS website for any additional questions.

Sources:
https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation
https://www.irs.gov/pub/irs-pdf/i1099msc.pdf
https://www.irs.gov/pub/irs-pdf/i1099gi.pdf