Do's and Don'ts When Using Contractors Effectively

Key Takeaways

• Using contractors can reduce overhead costs, but businesses must avoid employee misclassification risks.
• Independent contractors provide flexibility, specialized expertise, and efficiency without long-term commitments.
• A clear contract should include ownership clauses, payment terms, confidentiality, and termination rights.
• Businesses must avoid behaviors that make contractors look like employees, such as setting hours or providing tools.
• Hiring incorporated contractors reduces liability and misclassification risks.
• Challenges of using contractors include less control, higher turnover, potential uneven work quality, and audit risks.

There are several do's and don'ts of independent contractors. Independent contractors may be mutually beneficial for the employer and contractor, but classifying the difference between an employee and an independent contractor may not always be that easy. The Internal Revenue Service and the Department of Labor are cracking down on employee misclassification.

Benefits of Independent Contractors

An entity or person who is contracted to provide services or perform work for another business is referred to as an Independent Contractor (IC). ICs are required to pay their own Medicare taxes and Social Security. Many companies in the United States utilize ICs.

The relationship between a company and an IC is mutually beneficial. The company gains a qualified professional who is highly experienced in their field. The worker gains the flexibility to work for more than one company and can provide services when they choose. Additionally, companies appreciate that they do not have the legal responsibilities of a full-time employee which substantially decreases their costs.

Potential Drawbacks of Using Contractors

While there are clear benefits to hiring independent contractors, businesses should also weigh the disadvantages:

• Reduced control: Employers cannot closely direct how contractors perform tasks without risking misclassification.
• Inconsistent availability: Contractors often work on short-term projects and may not be available for ongoing needs.
• Variable work quality: Results may differ between contractors, making it harder to ensure consistency.
• Intellectual property risks: Unless contracts specify ownership, the contractor may retain copyright to created works.
• Injury liability: Contractors are not covered by workers’ compensation, meaning lawsuits are possible if they are injured on the job.
• Government audits: Agencies such as the IRS or Department of Labor scrutinize contractor relationships, and misclassification can trigger penalties.

Steps in Managing Independent Contractors

It is important to note that ICs must be managed much differently than hired employees. It is critical for a company to follow legal protocols when using ICs. If guidelines are not adhered to, significant problems may occur. For example, the government can reclassify an IC to employee status. This means the company will have to back-pay employment taxes to the government and be required to offer employee benefits to the IC if they decide to sue or claim unemployment benefits.

Essentially, a company will then need to advocate for itself against government agencies that support the ICs, such as the Illinois Department of Employment Security (IDES). This will result in significant financial losses and wasted time. When managing ICs, think of them as small, independent "mini-businesses."

ICs must be permitted to provide services in the manner in which they choose. It is not mandatory for ICs to adhere to your company's typical work methods. However, as their client, you can dictate deadlines and set requirements in the form of quantitative goals. Employers should not manage or supervise an IC in the same manner as they would a standard employee.

On the other hand, an employee is totally controlled by the employer. No matter how detailed, employees are required to follow corporate guidance, instructions, and the lawful rules of a workplace. Remember, businesses provide financial support to employees and assume a significant legal liability surrounding their employees.

Legal and Compliance Risks When Using Contractors

Using contractors requires careful compliance with tax and employment laws. Businesses should:

• Understand classification tests: Federal and state agencies use factors such as behavioral control, financial arrangements, and the nature of the relationship to determine whether a worker is truly a contractor.
• Anticipate audits: Misclassified contractors can lead to back taxes, unpaid benefits, fines, and liability for past overtime or wage claims.
• Plan for termination carefully: Unlike employees, contractors cannot always be terminated at will—termination terms must align with the written agreement.

What Should You Include in the Freelancer's Contract?

If an IC is creating content for your company, be sure to establish a "work made for hire" clause in the contract. This ensures that any content created by an IC is legally yours. These would include designs such as slogans, logos, and advertisements.

Key Clauses to Strengthen Contractor Agreements

In addition to a "work made for hire" clause, consider adding:

• Confidentiality and non-disclosure provisions to protect sensitive business information.
• Payment structure and invoicing terms to distinguish the contractor from employees.
• Independent business affirmation, where the contractor acknowledges they operate as their own business.
• Termination clause, setting conditions under which either party can end the agreement.
• Dispute resolution process, such as arbitration, to minimize litigation costs

What Should Be Considered When Hiring Independent Contractors?

Be sure to clarify if the IC is allowed to use the work created for the entity in work samples or authorship claims. Failure to document the specifics may mean that the IC may have ownership over any materials that have been created for you.

Do's: Put the Proper Documentation in Place

When hiring an IC, an employer should be sure to do the following:

• Have the IC sign an Independent Contractor Agreement.
• Clarify the terms of the business relationship.
• Confirm with the contractor that they are running their own independent business.

Do's: Best Practices for Using Contractors

Beyond basic documentation, businesses should:

• Issue Form 1099-NEC annually for payments of $600 or more.
• Verify the contractor’s business entity status, licenses, or insurance coverage.
• Keep records of invoices and payments to demonstrate an arm’s-length relationship.
• Use project-based pay schedules rather than salary-like arrangements.
• Ensure contractors market their services to other clients, reinforcing their independent status

Don'ts: Providing Tools and Supplies

ICs should never be provided with the equipment or materials necessary to complete their job unless absolutely necessary. When hiring an IC, an employer should never do the following:

• Pay ICs on a monthly, biweekly, or weekly basis.
• Pay them at the same time other outside vendors are compensated.
• Require ICs to submit invoices in order to receive payment.
• Provide new work to the IC once the project has been completed unless a new IC agreement has been authorized.
• Forbid the IC from utilizing subcontractors.
• Allow ICs to work in your office unless the prerequisites of the tasks require it.
• Provide employee policy manuals or handbooks.
• Over-supervise when it comes to training or ongoing instructions.
• Request frequent status reports.
• Formulate the working hours.

Common Mistakes That Lead to Misclassification

Employers should avoid these practices, as they can make a contractor appear to be an employee:

• Setting fixed work hours instead of allowing flexibility.
• Including contractors in employee benefit plans.
• Conducting formal performance reviews as if they were staff.
• Giving contractors company email addresses or business cards that imply employee status.
• Prohibiting contractors from working with other businesses

Advantages of Hiring Incorporated Independent Contractors

You can decrease the odds of IC misclassification by hiring ICs that have incorporated their own companies, rather than partnerships or sole proprietorships. A three-tiered relationship is created when you hire an IC. You'll be paying the IC's corporation, which pays the IC, who's technically an employee of the corporation.

Frequently Asked Questions

1. What are the main benefits of using contractors instead of employees?
   Contractors provide flexibility, specialized expertise, and cost savings since employers don’t pay benefits, payroll taxes, or insurance.
2. What are the risks of misclassifying an employee as a contractor?
   Misclassification can result in back taxes, penalties, unpaid benefits, and liability for wage and hour violations.
3. How should businesses pay contractors to stay compliant?
   Pay contractors by project or milestone, require invoices, and issue Form 1099-NEC rather than paying them like employees.
4. Can contractors be terminated at will like employees?
   Not always. Termination must follow the terms in the independent contractor agreement, or the business risks breach of contract claims.
5. What clauses should be in a contractor agreement?
   Important clauses include ownership of work, confidentiality, payment terms, termination rights, and acknowledgment of independent business status.

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