FAQ for People Working as Independent Contractors

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1. What is an independent contractor?

An independent contractor (IC) is a person who contracts to perform services for others, but who does not have the legal status of an employee. Most people who qualify as independent contractors follow their own trade, business or profession-that is, they are in business for themselves. This is why they are called "independent" contractors. They earn their livelihoods from their own independent businesses instead of depending upon an employer to earn a living.

Good examples of ICs are professionals with their own practices such as doctors, lawyers, dentists and accountants. However, you don't have to be a highfalutin doctor or lawyer to be an IC. Any person who is in business for himself or herself qualifies as an IC.

Independent contracting is not limited to highly specialized or technical fields like computer programming, engineering or accounting. There is hardly any job that ICs don't perform-from construction to marketing to nursing.

2. Why is the distinction between being an IC and an employee so important?

Whether you qualify as an employee or IC is important both to you and the firms that hire you because an employer-employee relationship is very different from the relationship between a hiring firm and an IC. Employees have a special legal status. Employers owe duties and responsibilities toward employees that do not exist when they hire ICs. Moreover, the tax treatment of employees is very different from that of ICs.

3. What are the benefits of being an independent contractor?

• You're Your Own Boss: When you're an IC, you're your own boss, with all the risks and rewards that entails. You decide who to work for, when to work and how to work. Many ICs report that the increased freedom they enjoy is the greatest benefit of being an IC.

• You May be Paid More than Employees: According to The Wall Street Journal, ICs are usually paid at least 20% to 40% more per hour than employees performing the same work. This is because hiring firms don't have to pay half of ICs' Social Security taxes, pay unemployment compensation taxes, provide workers' compensation coverage or employee benefits like health insurance and sick leave. All these items add at least 20% to 30% to employer payroll costs. ICs are supposed to pay for these things out of their own pockets and need to be paid more than employees to do so.

  Of course, exactly how much you're paid is a matter for negotiation between you and your clients. ICs whose skills are in great demand may receive far more than employees doing similar work.

• No Federal or State Tax Withholding: Another advantage of being an IC is that no federal or state taxes are withheld from your paychecks as they must be for employees. Instead, ICs normally pay estimated taxes directly to the IRS four times a year. This means you can hold on to your hard-earned money longer without having to turn it over to the IRS. Moreover, if you're an IC, it's up to you to decide how much estimated tax to pay, but there are penalties if you underpay. The lack of withholding and control over estimated tax payments can result in improved cash flow for ICs as compared with employees.

• Increased Business Deductions: Finally, when you're in business for yourself you can take many tax deductions that are limited or not available at all for employees. As an IC, you can deduct from your income tax any necessary expenses related to your business provided that they are reasonable in amount and ordinarily incurred by businesses of your type. This includes, for example: office rent and other expenses including those for home offices, travel expenses, entertainment and meal expenses (subject to limitations), equipment and insurance costs and more. In contrast, an employee's work-related deductions are severely limited.

4. What are the drawbacks of being an IC?

• No Job Security: When you're an employee, you must be paid as long as you have your job, even if your employer's business is slow. This is not the case when you're an IC. If you don't have business, you don't make any money.

  However, many would argue that there is no such thing as job security in modern America. According to The New York Times, more than 43 million employee jobs have been erased from the U.S. economy since 1979 and the trend continues.

• You Must Pay Self-Employment Taxes: Unlike employees who have half of their Social Security and Medicare taxes paid by their employers, ICs must pay all their Social Security and Medicare taxes themselves. These are called self-employment taxes. The self-employment tax rate is 12.4% of an IC's earnings up to the taxable limit for Social Security and a 2.9% Medicare tax on all IC income.

• No Employer-Provided Benefits: Although they are not required to by law, employers usually provide their employees with health insurance, paid vacations and paid sick leave. More generous employers may also provide retirement benefits, bonuses and even employee profit sharing.

  When you're an IC you get no such benefits. You must pay for your own health insurance, often at much higher rates than employers are able to pay. Time lost due to vacations and illness comes directly out of your bottom line. And you must fund your own retirement.

• No Unemployment Insurance Benefits: ICs also don't have the safety net provided by unemployment insurance. Hiring firms do not pay unemployment compensation taxes for ICs and ICs can't collect unemployment when their work for a client ends.

• No Employer-Provided Workers' Compensation: Employers must generally provide workers' compensation coverage for their employees. If you're an employee and are injured on the job, you're entitled to collect workers' compensation benefits even if the injury was your fault. Hiring firms do not provide workers' compensation coverage for ICs. If a work-related injury in an IC's fault, he or she has no recourse against the hiring firm.

• Few or No Labor Law Protections: A vast array of federal and state laws protect employees from unfair exploitation and discrimination by employers. For example, federal law protects workers who wish to unionize and requires many workers to be paid time and one-half for overtime. Few or none of these laws apply to ICs. ICs are not entitled by law to time and one-half for overtime. And hiring firms can refuse to deal with ICs who belong to a union or just express support for a union.

• Risk of Not Being Paid: If you're an employee, you have to be paid by your employer even if it's clients or customers fail to pay it. This is not the case when you're an IC. You bear the risk of loss from deadbeat clients. Many ICs have horror stories about clients who refused to pay them.

• Personal Liability for Business Debts: Finally, if you're a sole proprietor or partner in a partnership, you are personally liable for your business debts. Employees are not liable for the debts incurred by their employers. An employee will lose his or her job when the employer's business fails, but will owe nothing to the employer's creditors. If an IC whose business fails could lose everything he or she owns.

5. What happens if the IRS or other government agency determines that I'm really an employee, not an IC?

For example, if the IRS audits a hiring firm and determines that you should have been classified as an employee instead of an IC, it will impose substantial assessments and penalties on the firm--at the very least, the firm will have to pay an amount equal to 20% of the FICA taxes that should have been withheld from your pay, 100% of the FICA and federal unemployment taxes the employer should have paid itself, a penalty equal to 1.5% of your compensation, interest and sometimes other hefty penalties as well.

No IRS penalties or assessments will be imposed on you. But, you might lose certain business deductions because business expenses like home offices and health insurance premiums are not deductible for employees or the deductions are limited.

Audits by state workers' compensation, unemployment compensation and tax agencies can also result in assessments and penalties being imposed on the hiring firm, but not on you.

Even though it is the employer--not you--who has to pay the penalties imposed by the government for misclassification, you can still suffer greatly if the IRS or other agency determines that a hiring firm should classify you as an employee. For one thing, the firm may dispense with your services because it doesn't want to pay the additional expenses involved in treating you like an employee. Or, the hiring firm may insist on reducing your compensation to make up for the extra employee expenses.

6. What Legal Tests are Used to Determine Whether Workers are ICs or Employees?

• the Internal Revenue Service
• state unemployment compensation insurance agencies
• state workers' compensation insurance agencies
• state tax departments
• the United States Labor Department
• the National Labor Relations Board.

7. What Test does The IRS Use?

In contrast, ICs are not controlled by the firms that hire them. A hiring firm's control is limited to accepting or rejecting the final results an IC achieves.

8. How does the IRS Measure Control?

• can earn a profit or suffer a loss from the activity
• is told where to work by the hiring firm
• offers his or her services to the general public
• can be fired by the hiring firm
• furnishes the tools and materials needed to do the work
• is paid by the job or by the hour
• works for more than one firm at a time
• has a continuing relationship with the hiring firm
• invests in equipment and facilities
• pays his or her own business and traveling expenses
• has the right to quit without incurring liability
• receives instructions from the hiring firm
• is told in what sequence or order to work by the hiring firm
• receives training from the hiring firm
• performs the services personally
• hires and pays assistants
• sets his or her own working hours
• works full-time for the hiring firm
• provides regular oral or written progress reports to the hiring firm
• provides services that are an integral part of the hiring firm's day-to-day operations.

• Note: The IRS has recently issued a new training manual discussing the 20-factor test. The manual deemphasizes some factors that were formally considered important. Click here for a detailed discussion.

9. What Other Legal Tests are Used?

State workers' compensation, unemployment compensation and tax agencies use various tests to determine worker status. Many use the common law right of control test, but emphasize different factors than the IRS. Some use an economic reality test that focuses on whether a worker is economically dependent upon a hiring firm.

Many state unemployment compensation agencies use a special statutory test, also called the ABC test. This test focuses on just a few factors:

• whether the hiring firm controls the worker on the job
• whether the worker is operating an independent business, and
• where the work is performed--that is, where the hiring firm says or where the worker wants to work.

10. Should I Use Written IC Agreements?

A written IC agreement can also help establish your IC status. Although an agreement by itself is never enough to make a worker an IC, it will help show the IRS and other agencies that both you and the hiring firm intended to create a hiring firm-IC relationship, not an employer-employee relationship. Newly published IRS training materials state that where all the other factors are evenly balanced, a written IC agreement may tip the scale to the IC side.

But remember, an IC agreement is only useful if it's obeyed. It will be useless if you act and are treated like an employee.