How small businesses can use independent contractors and avoid problems with the IRS and other agencies

I use a lot of independent contractors in my small business. Can you blame me?

With an independent contractor (or freelancer, the terms are interchangeable), I don’t have to incur certain employer-related expenses, like Medicare, Social Security, and unemployment contributions, or provide health or retirement benefits.

At the same time, the independent contractors who work for me have more independence and flexibility as to when they want to work and how much they want to charge, among other things. It’s no wonder that the number of independent contractors has swelled to more than 15 million, according to a 2018 report from the Bureau of Labor Statistics.

But not everyone is always happy with that arrangement. Sometimes independent contractors want to be treated as employees so that they can take advantage of retirement and other benefits as well as receive protection under labor laws. This presents a challenge to both small and large companies.

Just last week, for example, hundreds of drivers working for ride-sharing services Lyft and Uber went on strike to protest both companies’ classification of them as independent contractors instead of employees. Over the last decade, thousands of independent contractors have forced big companies like Microsoft, FedEx, Bimbo Bakeries, and Lowe’s (as well as many other lesser-known companies in the transportation, oil and gas, and cleaning and janitorial industries) to reclassify them as employees after taking into consideration both federal and state rules.

But the rules vary depending on whom you’re asking. The IRS, for example, wants to make sure that you, the employer, are not exerting undue influence over your worker’s behavior and financial control, and that your relationship is strictly at arm’s length. The U.S. Department of Labor is more concerned with whether workers are protected under the Fair Labor Standards Act. Most states, including Pennsylvania, New Jersey, and Delaware, also have rules that take into consideration other factors, including whether your independent contractor’s work is considered to be core to your company’s operations.

It’s confusing, and the landscape is changing. So how can you make sure you’ve got your bases covered? I recommend these actions:

Formalize your relationship. Each of your contractors should be made to sign an independent contractor agreement. You can find good templates for these at sites such as LegalZoom and Rocket Lawyer. The agreement should state that you are in compliance with all federal and local laws and regulations that apply to your relationship. It should be clear that your company does not exert undo control over the contractor’s behavior and finances, and that the relationship the contractor has with you is strictly as a third party. The agreement should be updated and re-executed every year.

Stay on top of all filings. For contractors that have been paid more than $600 in a calendar year, you will need to send by the end of January a Form 1099 to both the IRS and the contractor. Make sure you strictly comply with these rules and maintain all documentation supporting the work performed.

Keep the contractor at arm's length. Some clients I know have a special "payroll" for their independent contractors. Don't do this! Pay your contractors as you would any vendor. Make sure they submit an invoice for their work and that you comply with their payment terms. Contractors should receive no additional benefits from your company other than what they've billed you. In all circumstances, treat them as an outside party.

Get an adviser. Depending on how many independent contractors you use, the stakes for your company could be very high. If a contractor is found to have been incorrectly classified, you may not only owe back taxes, interest and penalties, but be made to catch up on required retirement contributions that were not made in the past. Considering how costly this can be, the benefits of having an expert — your attorney, accountant or payroll service company — review your relationships is substantial.

In my experience, it’s unlikely that you’ll get audited by the IRS or Labor Department — state or federal. But — like Lyft, Uber, and many other companies — your contactors may decide to bring your company to the attention of these agencies if they feel they are misclassified and are losing out on additional benefits. Because the rules are subject to interpretation, there’s no guarantee that you’ll prevail. But I promise you’ll be in a stronger position if you follow the above recommendations.