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Independent Contractors

By Peter Jason Riley

Many companies use independent contractors to slash payroll taxes and reduce the cost of fringe benefits, but using outside workers can result in other problems. Itís no secret that the IRS often wages battle with businesses over freelancers. And contractors who claim they were really employees in disguise have sued numerous companies.

Latest example: A Texas jury ordered Mary Kay Inc. to pay $11.2 million, including $10 million in punitive damages, in a wrongful termination lawsuit. The case was filed after the cosmetics firm fired Claudine Woolf, one of its sales directors. She was unable to meet an $8,000 monthly quota after she became pregnant and was diagnosed with breast cancer two weeks later. Mary Kay claimed Woolf was an independent contractor, not an employee, and was not legally entitled to sue for wrongful termination.

The jury disagreed and found that Mary Kay was guilty of disability discrimination because it did not accommodate Woolf's request for a reprieve from her monthly sales requirements. The sales manager's company car was also repossessed.

Woolf's attorney argued that she was an employee managing a 50-person sales force under the direction of Mary Kay. However, Woolf signed an agreement with Mary Kay stipulating that she was an independent contractor and she filed federal tax returns as a self-employed person. Mary Kay is appealing the decision. (Woolf v. Mary Kay Inc. Dallas Co., Texas Dist. Court 2002)

The case is the latest in a long list of court filings against companies that use independent contractors. In some cases, workers sue for benefits they claim they were eligible for, including health insurance and retirement plan contributions.

To make matters worse, the IRS continues cracking down on companies that hire independent contractors. If the tax agency "reclassifies" a worker as an employee, your company could be slapped with hefty bills for back taxes, interest and penalties. Audits by state agencies are also common and frequently occur when freelancers apply for unemployment compensation.

So how can you protect your money-saving use of independent contractors? The issue is complicated so consult with your tax adviser but here's a rule of thumb: Workers are considered contractors if you have little control over how they get the job done. The more direction they get, the more likely the IRS would classify them as employees.

Unfortunately, no single factor determines a worker's legal status. The IRS looks at a number of issues, such as:
Tools ~ Employer usually give tools, equipment and workspace to employees. In contrast, contractors often provide and invest their own money in these items.
Assistants ~ Employees don't hire and pay anyone to help them do their jobs. But contractors often hire, supervise, and pay their own assistants.
Exclusivity ~ Independent contractors make themselves available to the general public and are generally free to work for two or more businesses.
Hours ~ Employees often have set schedules, while contractors are allowed more flexibility. (However, the IRS recognizes that some work, by its very nature, must be done at specific times.)
Pay ~ Employees are generally paid hourly or weekly, while independent contractors are paid by the job. It's a good idea to require contractors to submit invoices since they provide proof of non-employee status.

With those guidelines in mind, here are five more tips to safeguard your company:

  1. Consistently treat all workers performing similar tasks as either independent contractors or employees. If contractors wear ID badges or use company vehicles make sure their contracts explain why. For example, a policy was instituted after customers expressed safety concerns about deliveries in unmarked cars.
  2. Give outside workers leeway over how they perform their duties. Resist the urge to supervise them the way you oversee employees.
  3. Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year. For any tax year, you must give recipients 1099s by January 31st the following year.
  4. Don't supply freelancers with services you give employees. Some companies run into trouble when they provide office space, computers, cars and other perks.
  5. Maintain good records. Obviously, you need to keep an independent contractor's taxpayer ID number and other information required by the IRS, but you should also keep items that help prove the person is self-employed. For example, business cards, a letterhead, invoices and advertisements placed in newspapers. A simple listing in the yellow pages of the phone book is sometimes enough to convince an IRS auditor that independent contractors are in business for themselves.

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