If you hire an independent contractor, the Internal Revenue Service wants to know about it. The paperwork you need to provide is pretty basic; the tricky part is documenting that the person you hired is an independent contractor and not an employee.
When you hire contractors, make sure they complete a Form W-9 and provide you their contact information and Social Security numbers or business employer identification numbers. You need to keep W-9 forms for at least four years in case the IRS has any questions. Your business does not have to withhold any taxes from a contractor’s payments or remit anything to the IRS on their behalf, including Social Security, Medicare, or unemployment tax. The contractor pays those in their own annual taxes.
Keep careful track of how much you pay the contractor during the year. At the end of the year, you need to report the total amount you paid on Form 1099-MISC. You must send a copy of this form to the contractor by January 31 of the following year and to the IRS by February 28 (or March 31 if you file electronically).
Contractors use this form to report their income from your business. The IRS compares contractor and employer income reports. If the 1099 amounts don’t match up, that’s a red flag to the IRS that one of the parties hasn’t appropriately reported their income or expenditures.
Contractors may have their own employees or contractors working for them, but don’t worry; the tax responsibilities for those workers belong to the contractor, not you.
It’s important that your business be able to document that the independent contractor you hired really was a contractor and not an employee. The IRS looks at this issue closely because companies might try to pass off employees as independent contractors to avoid their tax responsibilities.
The IRS looks at four factors to determine if workers are contractors:
- Behavior: Does your company dictate when, where, and how the workers do their jobs, or are the workers free to do their work as they see fit? If you are defining the parameters of how the work is accomplished, the IRS views that as more of an employee relationship.
- Finances: Does your company control the business side of contractors’ lives? For instance, do you require they work with company tools you provide, or mandate monthly paychecks instead of letting them bill you when they want and use their own equipment? Contractors are usually free to use the tools they want and submit bills as they complete work.
- Relationship: Does your contractor compensation include benefits such as insurance, vacation time, or a retirement plan? This will look to the IRS more like an employee hire.
- Duration: How long is the contract for? If a contractor relationship is fairly full time and goes on for years, the IRS may consider the worker an employee. Workers may also sue for lost benefits if they believe they were unjustly denied employee status. For instance, in 2000, Microsoft paid nearly $100 million to settle a suit brought by many of its long-term temporary “contractors.”
If you are unsure whether your worker should be considered an employee or a contractor, you can ask the IRS to decide the issue by filling out and submitting Form SS-8. It may take six months to get a decision from the IRS, so be sure to keep all paperwork relating to the contractor in the meantime.
Business reporter Carol Tice contributes to several national and regional publications.