With the high cost of employee benefits hitting small companies where it hurts most -- on the bottom line -- a growing number of owners are fighting back by replacing employees with independent contractors.
The benefits are clear: Rather than paying employees fixed wages plus costly benefits, employers using contractors pay only for work performed. Although this approach can cut payroll costs, it can bring head-to-head conflict with the Internal Revenue Service.
The potential for conflict revolves around the definition of an independent contractor. Simply removing an individual from the payroll, and paying him on a per-project basis, does not mean he is no longer an employee. Not as far as the IRS is concerned.
"The IRS has a vested interest in making certain that those who are treated as contractors qualify for that designation," says Stuart Duhl, a partner with the law firm of Schwartz & Freeman.
"That's because employers are required to pay payroll taxes for employees but not for independent contractors. So every person removed from the payroll may mean less money for the government."
To prevent abuses in this area, the IRS has established a series of guidelines to determine if an individual qualifies as an independent contractor. If these provisions are not met, the individual will be considered an employee by the IRS, which may assess back payroll taxes plus interest and penalties.
With this in mind, employers will want to exercise care in designating workers as independent contractors. To determine whether contractor classification is fair, the IRS will apply the following tests:
* Independent contractors should have considerable discretion over when and how often they work. Unlike employees, who must conform to a set work schedule, contractors generally work on a per-project basis. The case for treating them as independent contractors is also enhanced if they work for more than one employer.
* Workers performing most or all of their duties at a single place of business are most likely to be treated as employees -- especially if their tools or equipment are provided or paid for by the company.
* Workers who participate in a company's training programs, or are given extensive instruction by supervisors, will likely be viewed as employees by the IRS.
Employers seeking to safeguard the status of independent contractors are advised to take the following steps:
Execute a written contract with the worker, specifying that he is an independent contractor and that he will be responsible for his own payroll taxes.
Give the worker explicit permission to work for other employers.
Permit the contractor to set his own schedule, including the number of days and hours he chooses to be on the job. However, to make sure that the work is finished on time, you can specify a date for completion of the project.
"The IRS crackdown shouldn't deter companies that legitimately treat workers as independent contractors from continuing to do so," Duhl says. "But it's more important than ever to document that these people are independent, and as such that they are not subject to the same control you exercise over employees."