Working with Independent Contractors: Know the IRS Rules and Regulations

irs independent contractor
IRS Definition Independent Contractor

Many businesses choose to work with independent contractors. And that's okay. It’s perfectly legal to rely on contractors for many different services. However, the IRS has strict rules around who can be a contractor and who is an employee under the law. And the penalties for getting it wrong include having to pay back taxes and significant fines.

So how does the IRS define a contractor?

The IRS uses the Common Law Rules, which look at several factors across three categories:

  1. How you BEHAVE toward the worker,
  2. The FINANCIAL arrangement you have with the worker,
  3. The nature of the RELATIONSHIP with the worker.

The Behavior Category

In this category, the main question is whether you are acting like a "boss." If you're working with independent contractors, you are not their employer, and they are not your employees.

That means you shouldn't dictate how, when and where contractors do the work. For instance, you shouldn't set work hours for your contractors, assign them an office or provide them with tools. You should treat them as a vendor.

Next, you shouldn't provide training to do the work. It's fine if you need to give new contractors an overview of your business, your products or your customers, but you shouldn't be teaching contractors essential skills to do the job, such as how to use a particular software.

Finally, do you monitor performance? It's okay to ask for progress reports to monitor how a project is coming along, but you shouldn't be conducting performance reviews or taking disciplinary action, as you would with an employee.

The Financial Category

For this category, you should ask yourself these questions:

  • Does the worker pay for his/her own business expenses? Independent contractors may bill you for some of their expenses, but they should pay them up front.
  • Does the worker own his or her equipment? Independent contractors should use their own computer, work vehicle, tools, etc.
  • Does the worker have other customers? Contractors should be free to pursue other projects.
  • Is the worker paid by the project? To be a contractor, workers should not be paid an hourly rate or on a salary basis.
  • Does the worker have an opportunity to make a profit or loss? Contractors have the possibility of incurring a loss.

The Relationship Category

This category explores the relationship between you and the worker. For example, is there a written contract that says the worker is an independent contractor? This can go a long way to show intent on both your parts. Or are you providing benefits, such as paid time off? That could indicate an employee relationship.

Other factors include the length of the relationship. Using an independent contractor should be temporary. The more permanent — or even long-term — the more it is going to be considered an employee relationship.

In addition, contractors should not provide your core business services. If you use a contractor to build a website for your construction company, that’s not a core business service. But if you use a contractor to build websites for your clients as your primary service, that’s more likely to be considered an employee relationship.

Classify Contractors Correctly

If you have any doubt about a worker’s status, it’s always best to err on the side of caution and treat the worker as an employee. For more information, check out the independent contractor section of the IRS website.

Note: Beginning with calendar year 2020, the IRS will be using form 1099-NEC for reporting independent contractor earnings.

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