Hiring Contractors – Part 1

Posted on Posted in COO, Hiring Consultants, Hiring Contractors, HR

Independent Contractors or Independent Consultants are people who do work for your company who are not employees, corporations or LLCs. Hiring independent contractors is attractive to startups because it allows them to quickly bring on talent without the headache of setting up payroll and benefits. Independent contractors also make it easy to bring people onboard for as long or as little as needed without worrying about employment laws that apply to hiring and discharging of regular employees. Without the added expense of benefits, matching FICA payments, and perhaps even office space and equipment, independent contractors can offer real savings and cash flow benefits to a startup organization.

But there are some legal pitfalls to hiring independent contractors that most startups (and many established companies for that matter) don’t understand. This post is the first of a three part series that helps to explain some of those potential pitfalls, so that you can make an informed decision before hiring an independent contractor.

There are many aspects to engaging with contractors including the fundamental question of whether or not to hire or contract for a given role, managing contractors to get the result that you want, and sourcing a quality contractor, to name a few. Once you’ve made a decision to hire a contractor, perhaps the most important thing for you to do is to make sure that a contractor cannot be construed as an employee of your company. Get this right and contractors can help you rapidly launch your startup. Get it wrong and it can be a costly and time consuming problem for you about one to three years down the road, just when you can least afford a serious distraction.

Before we go any further, let me clearly state that I am not a lawyer and the following should not be construed as legal advice. Before hiring independent contractors you should speak to your own legal and tax professionals for advice on whether or not any of this applies to your specific situation. Still, I have been an independent contractor, was CEO of an IT consulting company for thirteen years and, as COO of two startup companies, have hired hundreds of independent contractors. So, I think I can provide unique insights into the company-contractor relationship from both sides of the equation.

A Brief History of the Issues with Hiring Independent Contractors
The Internal Revenue Service (IRS) is the body that requires companies to distinguish between independent contractors and employees. The history behind this is somewhat interesting, but it all boils down to who pays the IRS (a company or the contractor) and how the IRS can get its money as quickly as possible. Since the IRS is at the root of the matter, the issue of a potential employee-employer relationship being created by incorrectly hiring a contractor applies only to U.S. companies engaging U.S. based independent contractors. It does not apply to engaging with foreign contractors (however, there are some other considerations that come into play here as well).

It was Section 1706 of the Tax Reform Act of 1986 that changed the nature of hiring contractors by making it illegal for computer programmers, engineers, designers, draftspersons and several other technical professionals to claim a self-employed status. As with most laws passed by Congress, lawyers and accountants were exempted. After 1706 was passed, most states added similar language to their state tax laws.

Senator Patrick Moynihan of New York introduced Section 1706 ostensibly to offset or pay for tax revenue losses caused by the Tax Reform Act of 1986. However, I’ve heard two rumors as to the “real” reason for the law. Both involve IBM, whose headquarters being in Armonk, New York, made them an influential constituent of the senator. Rumor has it that 1706 allowed IBM to either reduce taxes on foreign professional service revenue, or it helped IBM protect its massive professional services business by squelching the burgeoning independent consultant trade caused by the confluence of the advent of personal computers and the dawn of corporate downsizing in the U.S. in the 1980’s. I tend to favor the later explanation over the former, but have no idea if either is true.

Senator Moynihan was able to convince his fellow senators that self-employed skilled technical contractors were a bad risk for making timely or full payments to the IRS of their self-employment taxes. In order to assure that the IRS get withholdings or estimated payments from self-employed contractors as soon as possible, 1706 made it mandatory for contractors working through brokers to become W-2 employees of those brokers or, in order to contract directly with clients, to bear the burden of proof that they were legitimate self-employed “businesses”. Because 1706 carries the threat of penalties plus payment of back taxes and benefits to companies hiring independent contractors, the law had the effect of putting thousands of independent self-employed skilled contractors out of business (you can decide for yourself if that would that be a good thing for IBM’s professional services division).

I had been an independent contractor to a large Silicon Valley high tech company for three years when 1706 passed. Then, in 1988, in order to continue working for the company, they gave me an ultimatum of either going to work for a broker or forming a corporation, either of which would make me subject to W-2 wages and withholdings from a “third-party” entity. My client would therefore be off the hook for any potential employee-employer relationship liability.

The provisions of 1706 exist to this day and it is imperative for you to be aware of the potential problems it could cause for your startup down the road. For example, in the mid 1990’s the IRS deemed Microsoft to be the employer of many of the contractors who had been working for the company for many years (the 80’s and early 90’s were Microsoft’s most explosive growth period). This led to IRS fines as well as civil litigation which Microsoft ultimately settled in 2003 by paying $97 Million to 15,000 former contractors and their attorneys.

What You Need to Understand In Order to Properly Hire Independent Contractors
Employees are paid wages and are subject to tax withholding. Employee withholdings are paid to the IRS and state agencies each payroll period. At the end of a calendar year companies are required to issue each employee a W-2.

Independent contractor fees are not subject to tax withholding (with some exceptions). Independent contractors are required to pay estimated taxes (on their own) to the IRS or other state agencies each quarter during a calendar year. At the end of each calendar year if an independent contractor is paid $650 or more, the hiring company is required to report those fees to the IRS and issue a 1099-MISC to the independent contractor.

Failure to treat the contractor/client relationship properly can result in the IRS deeming it as an employee/employer relationship with the company having to pay back-withholdings, penalties, interest and/or back-benefits. In other words, by establishing or maintaining the relationship improperly, the IRS can make a determination that an independent contractor is, in fact, an employee of the hiring company.

The IRS has establish some guidelines for determining if one is a contractor or an employee and these guidelines are generally referred to as the “20 Questions” (see Rev. Rul. 87-41). If someone can answer yes to most of the 20 questions, they are likely to pass muster as an independent contractor.

The surest way to be sure that an independent contractor cannot be construed as an employee of your company is to establish that they are paying regular withholdings as a W-2 employee of some other entity such as a third-party broker corporation, the contractor’s own corporation or as an employee of an LLC. In this case, your company will be contracting with a corporation or LLC and not with an individual sole proprietor. You are not required to issue a 1099-MISC to a corporate entity and corporations are not subject to W-2 withholdings.

Beware of independent contractors acting as sole proprietors and using a business name that may or may not be properly registered as a fictitious business name. Sole proprietors are required to pay self-employment taxes and must do so in a timely manner which is generally through quarterly estimated tax payments.

If you pay a sole proprietor more than $650 in a calendar year you are required to issue a 1099-MISC to them by January 31 of the following year. But that is not enough to get you off the hook. If that sole proprietor does not make timely payments to the IRS or takes business deductions on Schedule C of their annual 1040 tax return that are “audit flags” to the IRS, they may be audited at any time up to three years after they file their return. Once audited, the IRS may determine that the sole proprietor was not an independent contractor but, in fact, an employee of your company and that’s when you will be swept up into an expensive and time consuming tax action.

Be especially aware of a sole proprietors who have “employees” or “partners” who may also be sole proprietors. If the partner or “employee” is providing services to your firm and the sole proprietor is paying these other persons without withholding taxes, they too could be construed as employees of your company during an IRS audit.

The advent of online freelance or guru websites where you can post contract requisitions, engage independent contractors and pay a fixed rate or fee through the site’s escrow services does not exempt you from exposure to the contractor/client relationship being construed as an employee/employer relationship if you are engaging U.S. based contractors. Be sure to read the fine print of the terms of agreement section of the site because you will likely find that the site makes you specifically liable for the relationship. They are specifically exempting themselves as responsible for determining if the contractor is properly organized and/or paying taxes in a timely manner.

What You Need to Do In Order to Properly Hire Independent Contractors
1. Become familiar with Section 1706 and the 20 Questions
2. Whenever you hire an independent contractor, be sure your legal agreement incorporates language consistent with the 20 questions that will stand up in a tax court three or four years from now.
3. If two independent contractors are available to you for a particular engagement, favor the one who is incorporated over the sole proprietor if the sole proprietor cannot answer the preponderance of the 20 questions affirmatively.
4. If you hire an independent contractor who is a sole proprietor, be sure to have them fill out an IRS form W-9, before you issue any payments to them.
5. Don’t treat independent contractors like employees. i.e. don’t give them business cards; don’t introduce them to partners, customers or investors as employees; don’t invite them to company functions such as holiday parties and all-hands meetings; don’t give them a company email address or publish their name in your company directory.
6. Make sure that you are not the independent contractor’s only client and/or don’t let them work solely for your company for more than eleven months.
7. If you hire U.S. contractors through an online site, be sure that you can have the contractor sign some agreement directly with your company that makes it clear that they are not an employee. Also make sure the online site provides your company with a copy of the 1099-MISC issued to the contractor at the end of the year for your records.

In Closing
Independent contractors can be a great resource for your startup allowing you to hire the senior talent that you need and who you otherwise could not afford to hire on a fulltime basis due to their high salary, total compensation needs or geographical proximity. Independent contractors don’t require stock options, HR and payroll hassles, but can be as productive and trusted as your best employees. Contractors tend to stay out of office politics and are generally focused on the specific task at hand. Therefore, they can often provide unbiased and objective advice which, as a manager, you should always be seeking.

Just be sure that the contractor you engage with is a real “professional” and understands that a proper arm’s length relationship is important for your company and his or her practice. If the contractor is a sole proprietor, make sure you take steps to protect yourself and your company from exposure to violation of section 1706 of the Tax Reform Act of 1986.

In Part 2 of this series I’ll discuss how to draw up proper independent contractor agreements that will minimize your risk of exposure to independent contractors being construed as employees. In Part 3 of this series I’ll discuss the 20 Questions and provide some examples of questions I’ve received from my employees and contractors when they are in the process of preparing and signing independent contractor agreements.

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