Pay Contractors like Contractors, or Pay the Consequences

If you don't want to risk turning independent contractors into employees, you should definitely pay them differently. Employees are generally paid in units of time: hours, days, weeks, months, and so on. Independent contractors, on the other hand, are paid on a project basis or by commission, although some are paid by the hour (for example, psychiatrists and attorneys). All things being equal, a worker paid in units of time is more likely to be deemed an employee than an independent contractor.

An employer must also withhold income tax, Social Security, Medicare, and unemployment tax from employee wages. Independent contractors, however, are responsible for paying their own taxes and insurance. At the end of the year, payments to employees are reported on the W-2 form, whereas payments to independent contractors are reported on the 1099-MISC form.

It's important to understand and observe these and other legal and practical distinctions between employees and independent contractors. There are potentially serious financial consequences if "independent contractors" are later found to be "employees." The employer could be liable for unpaid taxes, insurance, severance pay, and other employee benefits for wrongfully classifying "employees" as "independent contractors" (as Microsoft recently discovered when it lost its legal battle to prevent scores of temporary workers from being reclassified as employees).

While no single factor rules, the IRS (or a court in the event of a lawsuit) will certainly consider payroll treatment of "independent contractors," should a question arise about whether a particular worker or group of workers was properly classified. See for more information.