After reading about the possible benefits you can get from ICs, you might be thinking: “I’ll never hire an employee again; I’ll just use independent contractors.” But be aware that there are some substantial risks involved in classifying workers as ICs.
1. Federal Audits
The IRS wants to see as many workers as possible classified as employees, not ICs, so that it can immediately collect taxes based on payroll withholding. Being pegged as employees also makes it far more difficult for workers to under-report their income or otherwise evade taxes. In recent years, the IRS has mounted an aggressive attack on employers who, in its view, misclassify employees as ICs.
If the IRS audits your business and determines that you have misclassified employees as ICs, it may impose substantial interest and penalties. Such assessments can easily put a small company out of business. The owners of an unincorporated business may be held personally liable for such assessments and penalties. But, even if your business is a corporation, you could still be held personally liable for the tax, interest and penalties.
Federal audits don’t end with the IRS. Other agencies can also get into the act. These include the Department of Labor, which enforces the federal minimum wage and hours laws; the National Labor Relations Board, which enforces employees’ federal right to unionize, and the Occupational Safety and Health Administration, which enforces workplace safety laws.
2. State Audits
Audits by state agencies are even more common than federal audits. State audits most frequently occur when workers classified as ICs apply for unemployment compensation after their services are terminated. Your state unemployment compensation agency will begin an investigation, and you may be subject to fines and penalties if it is determined that workers should have been classified as employees for unemployment compensation purposes.
If workers classified as ICs are injured on the job and apply for workers’ compensation benefits, you can expect an audit by your state workers’ compensation agency, because workers’ compensation benefits are for employees only. Very substantial penalties can be imposed on hiring firms that misclassify employees as ICs for workers’ compensation purposes. These include fines, penalties and court orders preventing you from doing business until you obtain workers’ compensation insurance.
Although not as common as unemployment insurance or workers’ compensation audits, your state tax agency may also conduct audits to ensure that your workers are properly classified for purposes of your state income tax law. Again, fines and penalties may be imposed for mis-classification of employees as ICs.
3. Loss of Control
Another possible drawback to classifying workers as ICs is that you lose control over the worker. Unlike employees, whom you can closely supervise and micromanage, independent contractors must be left alone to do the job you are paying them to do. If you help them too much or interfere too much in their performance, you risk turning them into employees.
Some business owners can’t stand not being in charge of everything and everybody involved with their business. They particularly want to be able to closely supervise their workers. If you want to control how a worker performs, classify him or her as an employee.
4. Loss of Continuity
Generally, employers use a particular IC only as needed for short-term projects. They should spread their hiring around and not rely too much on one IC. Having workers constantly coming and going can be inconvenient and disruptive for any workplace. And the quality of work you get from various ICs may be uneven. One reason businesses hire employees is to be able to depend on having the same workers available day after day.
5. Restrictions on Right to Fire
You do not have an unrestricted right to fire an IC as you do with most employees. Your right to terminate an IC’s services is limited by the terms of your agreement. If you terminate an IC who performs adequately and otherwise satisfies the terms of the agreement, you’ll be liable to the IC for breaking the agreement. In other words, the IC can sue you and get an order requiring you to pay a substantial amount of money in damages.
6. Liability for Injuries
Employees covered by workers’ compensation who are injured on the job cannot sue you for damages. They are allowed only to file workers’ compensation claims and receive workers’ compensation benefits. This is not the case with ICs. They can sue you for damages if they claim they were injured because of your negligence, such as your failure to provide a safe workplace. If the injuries are substantial and your negligence clear, you may end up being liable for large amounts of damages. When you hire ICs, you should have liability insurance to cover the costs of such lawsuits. This may or may not be cheaper than obtaining workers’ compensation insurance.
7. Possible Loss of Copyright Ownership
If you hire ICs to create works that can be copyrighted—for example, book chapters or photographs—you can pay for the work and yet not be considered the owner unless you use written agreements transferring copyright ownership in advance. This is not the case with employees.