Running and growing a profitable business is challenging. There is no definitive guide on how to operate, including dealing with the complex regulatory and tax rules that surround being an employer.
Hiring independent contractors are an essential part of running a business, now more than ever. In many cases, it doesn't make sense to hire a full-time W2 worker when you need extra labor. Or maybe the work is specialized in nature, and you don't have the in-house expertise to finish the job.
As a business owner, you need to know how to legally engage these 1099 independent contractors and incorporate contractor agreements (we share a sample agreement below). Here is an overview of how to get the extra help you need without violating federal regulations:
What is an independent contractor?
Determining whether a person is an independent contractor or an employee can be complex. The IRS and Department of Labor have similar yet vague definitions, and each state might have its own definition for what constitutes a 1099 independent contractor in regard to workers compensation law. Generally, the IRS has a concise definition that we think summarizes the term:
"The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done."
In other words, determining whether a worker is an employee or an independent contractor is not based on how you pay them, but rather the amount of control you have over the individual.
Legally, the status of a worker will be determined by questions such as:
Does this independent contractor work for other companies or just me?
Do I instruct the independent contractor on how to do their job?
Do I provide the tools and equipment necessary for the independent contractor to do their job?
Do I train or provide training for the independent contractor?
If you exercise significant control over your independent contractor, train them on how to do their job, or provide them with tools -- your 1099 employee might be an employee of your company under IRS and Department of Labor standards.
If you think this could be an issue for you, we recommend talking with your accountant or attorney about how you should classify your labor.
4 Benefits Of Hiring Independent Contractors
Aside from determining what constitutes an independent contractor, it is important to know the pros and cons are of hiring this type of worker for your company:
1. More Staffing Flexibility
Hiring 1099 contractors allow you to bring on additional labor for a unique project, or scale your workforce up or down as the needs of the company fluctuate. If business is slow, you do not have to "fire" the employee or deal with unemployment insurance -- you can simply quit using their services.
2. Less Complexity
Having an independent contractor is significantly easier from an administrative standpoint. You do not have to worry about payroll taxes, benefits, severance pay, unemployment insurance, or many other managerial responsibilities that come with hiring an employee.
3. Lower Costs
Independent contractors have much lower overhead than company employees. Between benefits, HR administration, equipment, additional costs, and legal responsibilities of an employee, hiring an independent contractor is usually cheaper than a full-time employee.
4. Reduced Exposure To Lawsuits
Employees have rights protected by law (family and medical leave, equal employment opportunity, overtime restrictions, and many others) that independent contractors do not have. That’s not to say an independent contractor couldn't sue you, but labor laws are structured as a benefit for the W2 employees in your company. Breaking any of the federal or state laws that are associated with employee rights will put you at risk of a very serious lawsuit or legal action.
On the other hand, independent contractors are not subject to as many laws since they are technically self-employed. This significantly reduces your chances of an employment-related lawsuit.
4 Negatives Of Hiring Independent Contractors
1. Less Control
By definition, you have very little control over how independent contractors do their job, when they work, or what equipment they use. This can increase the chances of a workplace injury, or the work simply not being done exactly how you wanted.
2. More Turnover
The flexibility of having an independent contractor on board works both ways. With no benefits, no promise of regular hours, and an easily severable relationship, independent contractors can and do move around more frequently than their full-time employee counterparts.
For many businesses in high-skilled areas where knowledgeable employees are hard to find, this high risk of turnover can be a deal breaker. In other fields, not so much. The risk of having higher turnover is something you should evaluate in the context of your business operations.
3. Potential IRS Audits
Having a lot of 1099 independent contractors on your payroll subjects you to more IRS scrutiny. The IRS will commonly go into businesses that use independent contractors and do an audit of the type of work that’s being done to verify the independent contractors meet the legal requirements of the role.
If you do not meet all these requirements, you will be subject to some potentially harsh penalties, such as paying back taxes on their employee payroll if they were classified correctly. This is a significant risk that you should consider before hiring 1099 independent contractors.
4. Insurance Ramifications
Hiring too many independent contractors can be a red flag for insurance companies as it signals to them that you have a lot of uncontrollable risk in your business. Your lack of control over an independent contractor and potential turnover issues (which commonly lead to more insurance claims) can result in significantly higher premiums.
Are contracts necessary when hiring independent contractors?
Yes, having a signed contract with an independent contractor is essential. Your dealings with independent contractors should be similar to your dealings with other business entities. Payment structures, responsibilities, and ownership details should be written out the same as you would when working with a separate business.
We share a sample independent contractor agreement below, but first, here are the benefits of having one in place:
Establishes The Responsibilities Of Each Party
A good contract will help you establish what each party is responsible for in your working relationship. This could be who is responsible for materials, completion deadlines, legal liabilities, and more. If there is ever confusion or a dispute, you can always refer to the contract for clarity.
Limits Employer Liability
A quality independent contractor agreement will help lower the liability of an organization. Whether it be a non-solicitation clause to avoid a contractor poaching your clients, or hold-harmless language to avoid potential lawsuits, the right contract can help lower your risks when you hire independent contractors.
Sets Terms For Contract Termination
One of the benefits of hiring an independent contractor is the flexibility to scale your labor capabilities up or down on short notice. A good contract will help you establish how and when you can end or pause the relationship between your company and a 1099 independent contractor.
Establishes The Compensation Structure
A good contract will clarify the agreed-upon compensation structure between you and your independent contractor. This can include the payment rate per hour or their rate per project. It can also include terms about the frequency and dates that payments will be made.
Sample Independent Contractor Agreement
To help you understand what one of these documents should look like, this is our template for a simple independent contractor agreement:
Independent Contractor Sample ContractDownload
What Every Independent Contractor Agreement Should Have
Contract Term (Length of Agreement)
Specifies the length of your contractual relationship with the independent contractor. Typically, this is on an annual basis, meaning you need to choose to renew or not renew the agreement.
Description Of Services
Explains in detail the type of work that will be performed by the independent contractor.
Establishes how the independent contractor will get paid (such as, by the hour or per completed task) and the amount the contractor will be paid (e.g. an hourly rate of $100).
Waiver Of Contractor's Rights To Employee Benefits
States that the independent contractor is not an employee and therefore not entitled to any benefits an employee would receive.
Contract Termination Terms
Establishes the procedures and timelines to end a relationship with an independent contractor.
Indemnification & Hold Harmless
Limits the ability of the independent contractor to sue your company for issues that occur or arise during their relationship with your company.
Creates a duty for the independent contractor to not disclose any proprietary information about your company to competitors or any other party.
Limits the ability of the independent contractor to pursue your clients for a certain amount of time after having worked with you.
3 Things To Keep In Mind
1) Don’t assume that paying someone as a 1099 independent contractor means they are one.
Just because you pay someone as a 1099 independent contractor does not mean they are legally categorized as this role. What determines if they are an independent contractor is the level of control and the relationship you have with them.
If hiring independent contractors is a central part of your business strategy, we highly suggest talking with an accountant or lawyer for their opinion on how you should be classifying these workers.
2) Be aware that having too many independent contractors could impact your business insurance.
Insurance companies can get a little uneasy when businesses have a significant percentage of independent contractors on their payroll. The insurance carrier's goal is to find the best and lowest risk businesses in each category (e.g. the plumber that is least likely to file a claim).
Companies with a high number of independent contractors are in a situation where they cannot exert control over their workers, even though they will be responsible for any liability that arises out of the work product. This means that there is uncontrollable risk that makes insurance companies nervous.
This is an addressable issue, but something to consider as you hire independent contractors versus employees.
3) Have a defined process & checklist when hiring independent contractors.
To protect your business and keep operations running smoothly, establish an efficient process for hiring independent contractors that includes having them sign an agreement (and renewing the agreement each year). This will ensure that legal and work responsibilities are clear, while also making it easy for you to produce documents if the IRS audits your 1099 independent contractors.
Hiring independent contractors is a popular way to do business. It is important to establish a contractual relationship with you 1099s to clarify their responsibilities and lower the risks of hiring them to work with you.
If you want to know how independent contractors could potentially affect your insurance rates, give us a call to talk through the scenarios.