Establishing Yourself as an Independent Contractor

Definition

An independent contractor is broadly defined as an individual or organization contracted to perform a particular service or deliver a product. Independent contractors can also be consultants. Consultants are highly specialized experts in their field who generally work on strategic business concerns by providing advice, research and recommendations. The term "consultant" however, has been more loosely applied in recent years.

Consequences of misclassification

Computer consultants fall into a category of workers that can be potentially misclassified. Companies that treat "employees" as independent contractors are at risk of an IRS audit (through the state employment development department) for improperly classifying workers.

Consequences of misclassification errors have cost companies millions of dollars for unpaid state payroll taxes, workers comp, employer social security contributions, penalties, and interest. Your clients therefore will want to make sure that you fit the criteria of an independent consultant before they retain your services. If you don't pass this test, you may be hired as an employee (W-2'd), be eligible for whatever benefits are provided for that class of employee and will have taxes withheld from your wages.

Further, if the IRS or state employment authority determine that you are an employee when you have been acting like an independent contractor, you could lose any business deductions you have submitted to your state and federal income tax returns. To avoid these consequences, make sure that you have set up your business and render your services consistent with the IRS criteria.

IRS Criteria

In brief, as an independent contractor, your client has no right to control you as you work and no right to direct the manner in which the work is done. Clients are paying purely for the end result or deliverable of the project. Employers, on the other hand, control, direct and supervise their employers and pay them regular, time-based rates.

There are 20 factors the IRS uses to determine whether or not a person is an employee or independent contractor. You should familiarize yourself with these criteria and discuss them with an attorney who is familiar with employment law to ensure that you have organized your business and render services that meet the IRS criteria.

20 factors for independent contractor determination

If you do not meet ALL of the following four tests, you will not be seen as an independent contractor in the eyes of the IRS (nor therefore with your potential clients):

Profit or loss
You must be paid by the job and be able to make a profit or incur a loss for doing the job. The loss cannot be the result of just not getting paid; it must be a function of how your work is priced. Payment by the job includes a lump sum, which may be computed by the number of hours required to do the job at a fixed rate per hour. Your pricing scheme should allow you to make a profit if you work efficiently and lose money if the project takes more effort and time than you had estimated. Pure "by-the-hour" pay arrangements are questionable because there is no economic risk for the consultant.
Investment
You must have made a significant investment in equipment and facilities in which to work.
Services offered to the general public
You must offer your services to the public. Evidence of this includes having business cards, a business telephone listing, marketing material, and other clients, etc.
Works for more than one firm
You must be free to provide your services to more than one firm or person at the same time.

If you meet ANY of the remaining 16 criteria, you will probably be seen as an employee and not an independent contractor.

Instructions
Your client has the right to control or direct when, where and how you work whether he or she actually does or not.
Training
Your client provides training for you to carry out services for the project. Contractors rely upon their own resources for training and receive no training from their clients.
Integration
Your services are a necessary (and regular) part of your client's main line of business or business operations. This shows that you would likely be under the control and direction of an employer.
Services rendered personally
You must perform the services personally. This is an indication that the client is concerned with the method of execution and not just the end result. Contractors are able to hire a substitute without a client's knowledge.
Hiring assistants
If your client has control over or pays your staff directly, you will look like an employee to the IRS. Consultants hire, pay and supervise whomever they need to complete the project.
Continuing relationship
If you have an on-going relationship with, and work at frequently recurring, even if somewhat irregular, intervals for your client, you may be viewed as an employee. Independent contractors work on specific, discreet projects with specific delivery dates.
Set hours of work
Employers set employee work schedules. Contractors must be free to work at their own schedule. Contractors may establish a completion date for a project, but within that time frame, must be free to work when they please.
Exclusive full time hours
Requiring you to work full time indicates control and makes you an employee. Contractors are free to choose for whom they work and when.
Work done on premises
If you are expected to work at the client site and do not have the option of performing work elsewhere even if it could be done off site, you are likely in an employment rather than contracting relationship. Contractors are expected to work at their own facility and only visit the client site for occasional (not regular staff) meetings.
Sequence set of work
If your client can determine the sequence or order of the work you do (whether they actually do or not), this would indicate that you are within their control and direction and are therefore an employee.
Reports
If you are required to report on your activities, you are probably an employee.
Payment schedule
Employees are paid by the hour, week or month (or similar arrangement) and have no risk of losing money as they work. Independent contractors are usually paid by the job/project or on a straight commission.
Expenses
Employees are generally reimbursed by their employer for their expenses. Contractors are generally responsible for their own business expenses.
Tools and materials
Employers generally furnish tools and materials (regular office, telephone, laptop, etc.) for their employees. Contractors provide their own equipment and significant work materials.
Right to fire
Employee can be fired. A contractor cannot be fired so long as he or she produces the result specified in the contract. If a client terminates a contract not for cause, they may be at risk of a breach of the contract.
Right to quit
Employees can generally quit without incurring any liability. An independent contractor has an obligation to complete a specific job and is responsible for doing so satisfactorily or making good for failing to do so.

Reporting

Companies must report payments over $600 made to an independent contractor (an individual, partnership, estate or in some cases, a corporation) who is not an employee to the IRS via IRS Form 1099 (Miscellaneous Income). Your clients will provide you with a copy of the 1099 to submit with your tax return.

As an independent contractor, you are responsible for paying your own income tax and self-employment tax. By the same token, if you pay a contractor over $600, you must file IRS Form 1099 and provide a copy to the contractor.

Make sure any contractors you retain have met the IRS criteria. The following publications are available for free by calling 800 829 3676. They can help explain the issue more fully:

Publication 15 Circular E, Employers Tax Guide
Publication 937 Employment Taxes and Information Returns
SS-8 Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding

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