Independent contractors are easy. You basically just need a contract and a W-9 to get going. They are responsible for their own business licenses, insurance, taxes, books and records, and all of the other details required of an independent business. You just issue a 1099 at the end of the year.

Employees make things a little trickier. You typically need to report them to your state and local business licensing bodies. You need to withhold federal income tax and FICA for them. You need to pay unemployment contributions and worker’s compensation insurance. You may need to provide health insurance. They will be covered by overtime and minimum wage protections. Seattle even requires that you give them paid time off.

Now I realize you may be jumping to classify your new hire as an independent contractor. If only it were that simple. Unfortunately, nine times out of ten, that is the wrong move, and misclassification can land you in some hot water with state and federal taxing authorities.

As a general rule, if your new hire is destined to work under your control to support your business, you probably have an employee on your hands. However, if you expect her to perform a completely independent task that is only tangentially related to your business, you may be able to validly claim that she is an independent contractor.

To keep things interesting, every regulatory agency seems to have a different test to determine how you need to classify your new hire. Luckily there is a lot of overlap. Let’s take a look at a few different perspectives.

Labor & Industries

Worker’s compensation, or industrial insurance, varies from state to state. These statutes are intended to be broad in order to cover work-related injuries for the widest swath of the working population.

In Washington, the Department of Labor & Industries levies a tax on employers based on the number of hours their employees work. The amount of the tax varies greatly, depending on the risk classification for the type of work performed. A logging company will pay a much higher rate than an accounting firm will. Employers are not required to pay the tax on bona fide independent contractors.

There are several tests that may qualify your new hire as an independent contractor, but they are strict. The first test essentially asks whether she is bringing more than her own personal labor to the job, which can be done if either:

• She has her own employees and she is free from your control; OR
• She brings her own heavy or costly specialized equipment

If she doesn’t meet one of those, the second test will ask you to prove that she is really her own established business. To do this, all the provisions of this six part test have to be met:

• She is free from your supervision or control;
• Her work is performed outside of the usual course of your business, outside of your offices, or she is responsible for the costs of her own principal place of business;
• She has an established independent business that existed before you hired her or she has her own principal place of business that qualifies for an IRS deduction;
• She is responsible for filing her own schedule of expenses with the IRS;
• She has all the necessary state and local registrations and business licenses; AND
• She keeps her own books and records

The trick to successfully passing this test (and proving it on an audit) is to obtain all the necessary documentation up front. Before you even consider hiring her as an independent contractor, get her state business license. Get a profit and loss statement and balance sheet. Get a tax return. Do your due diligence and keep records of it. Then get an iron clad Independent Contractor Agreement that sets it all out in writing.

Be honest with yourself though. If your new hire simply won’t meet any of these tests, and does not qualify for another statutory exception, you have an employee and it is your responsibility to report her hours worked to L&I. Depending on your industry, you may simply want to look at it as really cheap insurance for any workplace accidents.

Employment Security Department

Both the Federal and state governments implemented legislation to provide unemployment benefits to folks who lose their jobs. Unfortunately for employers, that typically means the government is demanding contributions to unemployment insurance funds in the form of a tax on any wages paid to employees.

Washington’s Employment Security Act is administered by the Employment Security Department. The amount of the tax levied on wages paid to those “in employment” varies based on the experience of the employer and the type of industry. Certain job classifications are specifically excluded—like real estate agents, outside salespeople, and insurance brokers.  However, the statutory definition of employment is intended to be broad.

If the line of work you are hiring for does not fall into one of the specific exclusions, you may still be able to classify your new hire as an independent contractor if you pass the three prongs of this short statutory test:

• You have no control over the methods or details of her work;
• She either performs all of her work outside of your offices or performs a type of work that is different from your business’s core functionality; and
• She is customarily engaged in an independently established business or profession, meaning that she solicits her own business and will likely continue with the business without you

Because the test is stated in the conjunctive, it is not the easiest test to pass.

There is also a long test with six prongs that is substantially identical to Labor & Industries’ test above. Again, documentation is key.

Internal Revenue Service

Classification for purposes of FICA and income tax withholdings is slightly less rigid because it is not mandated by statute, but instead interpreted by the courts and your friendly local auditors. It is best to play on the safe side though because penalties can be steep.

For years the IRS used the “Twenty Factor” test, as set forth in Revenue Ruling 87-41. As the name would imply, it provided twenty factors that had to be analyzed and weighed to assess the nature of the employment relationship. It was unruly to say the least.

In 2012, the IRS issued Revenue Publication 3-2012 in an attempt to simplify things. The publication broke the analysis down into three groups: (1) Behavioral Control; (2) Financial Control; and (3) Relationship of the Parties.

Behavioral Control centers on whether or not you have control over the methods and details of how your new hire performs her work. If you are giving extensive instructions on how to do the job, she is probably an employee. Specifically, the IRS will look at whether you control:

• How, when and where the work is done
• What tools or equipment is used
• What assistants can be hired to help with the work
• Where supplies and services are purchased

Financial Control looks at whether you have a right to control the business part of the work, or whether your hire has sufficient financial independence to make her own decisions. The IRS will look at:

• Whether or not the hire has made a significant financial investment in her work
• Whether or not you reimburse her for some or all of her business expenses
• Whether she has the ability to recognize a profit or a loss

Finally, the IRS will look at how you and your hire perceive the arrangement. In particular, they will look at the contract, and at whether or not you are providing benefits.

There are lots of other agencies with their own factors, tests, and interpretations. It might sound overly complicated. It can be very complicated if you want to walk in the gray area—but it doesn’t have to be.

If you expect your new hire to work under you and help you run your business, save yourself some headache and just report her as an employee. The tradeoff of having control over an employee is more valuable than the concessions you will have to make to properly classify her as an independent contractor.

If you have hired her for her expertise in a particular field, and you fully expect her to work independently, tread carefully in classifying her as an independent contractor. Make sure you get all the documentation for your files up front. People are typically more accomodating when they want your business than after they have been paid and you are under audit.

Audit risk is simply a part of the business landscape today. I cannot reiterate enough how important documentation is on this issue. As the employer, you will be the one responsible for showing that your classification was proper and reasonable. The earlier you address the issue, the better off you will be. If you have the supporting documentation to show the auditor, you can quash it there. If you need to appeal, the process gets tougher. If you take it to court, the judge will be very deferential to the auditor’s findings.

If you have questions, give us a call. I am always around.

Thanks for reading,

Tim