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Employee or Independent Contractor: What Business Owner’s Need to Know

This week, we decided to reintroduce one of our archived, popular blogs. Let us know what you think!

Employees are expensive; misclassifying them as independent contractors is more so.

Most state laws require employers to pay for their employees’ workers’ compensation coverage and unemployment insurance…at a minimum. The Federal government imposes additional (and very expensive) requirements. Specifically, employers must:

  • Pay Social Security contributions of 6.2% of salary up to $106,800 (in 2009)
  • Withhold 1.45% of all earnings for Medicare
  • Pay overtime to eligible employees
  • Provide unpaid leave under the Family and Medical Leave Act for those companies to which the Act applies.

Independent contractors, on the other hand, receive 1099 forms at the end of the year and are responsible for their own taxes. Employers contribute nothing.

It is tempting, therefore — particularly in difficult economic times — for employers to classify people as independent contractors and save both the money and the headache of withholding taxes insurance payments, and contributions. But it’s not that easy. The IRS looks very carefully at each situation to determine the exact nature of the relationship between the company and the individual.  For the most part, it comes down to a question of control.

The IRS and most states examine the following factors to determine the nature of the relationship:

  1. The company’s right to direct or control how the work is being performed
  2. Who establishes training programs and whether they are mandatory
  3. The source of the tools (including computers and software) used to perform the work
  4. The location where the work is performed
  5. Whether the company has the right to assign additional projects
  6. Whether the hired party hires and pays his or her assistants or support staff
  7. The company’s right to determine when the work is performed and/or set certain hours

Bottom Line: If your company has the right to control or direct what is being done, how it is being done, and when it is being done, your company is most likely and employer.

Most importantly, a wrong answer can be extremely expensive. Companies which misclassify employees and independent contractors can be subject to huge tax bills for unpaid taxes as well as penalties for failure to file required tax forms and, in certain circumstances, failure to adhere to Federal and State statutes such as the Family and Medical Leave Act and Title VII of the Civil Rights Act of 1964, as amended (applicable to employers who have 15 or more employees). In addition, misclassified employees can pursue their own claims against the company for any losses they may have sustained.

Both companies and individuals can ask the IRS to make a determination of employment status by filing with the IRS Form SS-8:  Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.