Pros Cons of Independent Contractors

The Pros and Cons of 1099 Independent Contractors

If you need to hire some extra workers, adding a person who must be classified as an “employee” brings with it a set of obligations under state and federal labor and tax laws.  You generally must withhold from wages federal and state income tax, the employee’s share of Social Security and Medicare taxes, and the business must pay the employer’s share of Social Security and Medicare taxes, pay federal unemployment tax, worker compensation taxes, and complete the I-9 employment verification process (many companies must also E-Verify employees they hire).  Given these obligations, our clients frequently inquire as to whether it would be better to simply use 1099 independent contractors in some circumstances.  While it would undoubtedly be easier to use independent contractors, that approach is appropriate only in certain circumstances.


A.  What is a 1099 Independent Contractor

An “independent contractor” is an individual (or a company) that performs a service or provides a product to another company without entering into a traditional employment relationship.  Individuals who act as independent contractors are also sometimes referred to as “consultants,” “1099’s” or “1099 employees”, the latter of which are derived from the name of the IRS form that a company issues the contractor at years’ end for the work performed.  The employer benefits from this arrangement because it does not have to manage employment tax issues or provide fringe benefits (e.g., health insurance, paid vacations), and generally the company’s obligations end at issuing a Form 1099-MISC to report what was paid to the independent contractor for the work performed.  Independent contractors often work for a number of different clients at any given time and are not an “employee” of any particular company, but are most frequently self-employed and may even have formed their own company.


B.  Potential Company Liability: General Concerns

The company is generally not legally responsible for an independent contractor’s misdeeds.  However, that protection is not absolute, and there are occasions when businesses may find themselves legally liable, so they should be aware and try to work additional protections for the company into a written agreement with the contractor.  The general rule (Respondeat Superior) is that employers are responsible for the things that employees do in the course of their work.  But this rule does not extend to the actions of independent contractors because there is no employment relationship. There are nonetheless some circumstances where a company may find itself liable for acts of its independent contractors, including the following situations:

  • Sexual harassment – Employers have a duty to maintain workplaces that are free of sexual harassment. If an employer either knows or should know that an independent contractor is unlawfully harassing employees, the employer may be liable for failing to protect employees.
  • Agents – An employer’s agents may be employees, or they may be independent contractors. Under the general principles of agency law, if a third party is injured because of the actions of a non-employee agent, when the agent is acting on behalf of the principal/employer, both the agent and the employer may be liable.
  • Negligent hiring – Businesses also have a duty to screen independent contractors carefully. In some states, companies have a duty to its employees and to the public to exercise care in the hiring of independent contractors.


C.  Potential Company Liability: Misclassification of Employees

The biggest mistake that companies make (and the biggest source of potential liability) is misclassifying workers as independent contractors when they should be classified as employees.  Contrary to popular belief, a company and a worker cannot just decide to have an independent contractor relationship as opposed to an employment relationship.  Rather, the nature of the relationship is determined by the US Department of Labor (DOL) and the Internal Revenue Service (IRS) – both of whom have set out criteria for determining whether a worker is properly classified as an independent contractor.

The U.S. Department of Labor generally looks at how much control the business owner exercises over the way in which the worker accomplishes a task.  The IRS, which is interested in this distinction for tax purposes, looks at a longer list of factors including the worker’s expectation of the length of the arrangement, who owns the tools, where the work is accomplished, and whether the task is central or collateral to the business owner’s business.  The IRS pays particularly close attention to worker misclassification because it affects the revenue they collect from employment-based taxes.

The IRS and DOL are more likely to classify as an independent contractor a worker who:

  • can earn a profit or suffer a loss from the activity;
  • furnishes the tools and materials needed to do the work;
  • is paid by the job via invoice (not by the hour or via a salary through payroll);
  • works for more than one company at a time;
  • invests their own money in equipment and facilities;
  • pays his or her own business and traveling expenses;
  • has established their own distinct business structure (e.g., LLC or a corporation);
  • is not provided the option to join company-sponsored benefit programs; and
  • maintains separate business insurance that covers the work to be performed.

The penalties for misclassifying an employee can vary, depending on whether the DOL or the IRS is the agency handling the investigation.  Regardless, employers can expect to pay back wages (including overtime, if applicable), back payroll taxes, fines, penalties, and even attorneys’ fees. If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties including penalties that include 20% of all of the wages paid, plus 100% of the FICA taxes, both the employee’s and the employer’s share or criminal penalties of up to $1,000 per misclassified worker and one year in prison.


D.  Documenting an Independent Contractor Relationship

While no written agreement is technically required, it is a good idea to draft an Independent Contractor Agreement that spells out the rights and responsibilities of each party.  Taking this step will help resolve ambiguous situations in your favor, and may even illustrate the fact that the individual is not suited to be an independent contractor but should, instead, be hired as an employee. At a minimum, the agreement  should:

  • Refer to the worker as a contractor and refer to payments as contract payments (not wages);
  • not prevent the worker from taking on other projects;
  • not require full-time work for you or working every day on your premises;
  • Specify that payments should be due on completion of the project or at designated progress points;
  • Identify the duration of the relationship, rather than leaving it open-ended;
  • Decline to pay for business expenses incurred in the performance of the work, except in limited, specified instances;
  • Require the submission of invoices to get paid; and
  • Note that the worker will be issued a Form 1099 for the work performed.


E.  Takeaway for Employers

There is no denying that independent contractors impose less of an administrative burden and expense on employers.  However, companies do not have “carte blanche” to use independent contractors whenever they like.  Their use must fall in line with the guidelines and circumstances outlined by both the IRS and DOL.  The current trend among these agencies and the court system is to favor the employment relationship – which is another way of saying that the government is skeptical about the wide spread use of independent contractors.  Thus, employers should tread carefully.  Make sure the work you need performed is appropriate for an independent contractor, and document the relationship with an appropriate agreement.

C2 provides strategic HR outsourcing to clients who want to develop optimal workforce strategies and solutions to allow them to be more competitive and profitable. C2 blog posts are intended for educational and informational purposes only.