Employee vs independent contractor, help me win this argument.

Aaron nails this. This is a real risk. The Department of Labor is auditing this more and the Obama administration more than tripled their staff in certain locations (Chicago is one example). You need to get this under control and do it fast. Since you are closing in on a year end, you may want to determine if any withholding is necessary to protect yourself for the 2013 tax year.

Concur with comments and provide these points: Do you have employees who do the same/similar work as the independent contractors? Do you provide the "tools" to the independent contractor to complete their work product? Do you monitor the amount of time/effort the contractor expends in completing the work product? Are the assignments longer than 6 months? Generally, you classify 1099s for jobs you do not need long term. To your point, review the resources you need to execute the strategy both in the short-term and long-term and delineate those human capital resources. Hope this helps.

If your company has employees and independent contractors performing the same duties, there is significant risk of payroll taxes, penalties & fees upon audit. And the government has escalated this type of audit activity in recent years.

Independent contractors are typically paid higher rates than employees because they take on the liability and self-employment taxes. If upon audit they are deemed employees, your company will end up paying the higher contractor rate PLUS all of the other charges. You can't go back and negotiate an employee rate with each contractor.

If you provide a desk, computer and any kind of supervision and your contractor files for unemployment at the end of their project, the Department of Labor and the unemployment review panel who are adjudicating you denial to benefit will likely rule in the contractors favor and then the fines and penalties kick in.

Other things to consider: most of the contractors who have specialized knowledge are from out of town and come with an expensive ticket to cover travel home, lodging, car rental not to mention their fee. If your business is using long term contractors, I urge you to consider conversion to employment. At the end of the day, most contractors want steady employment and the benefits and sense of security that full-time employment offers which brings focus on your business and buys loyalty. If you are in at "At-Will" employment state and you follow the rules, then I advocate offering employment over the use of contactors. A popular choice these days is to use agency personnel on a Temp-to-Perm basis, a smart choice indeed.

Everything posted is true and correct. Pay attention to these warnings!!! I have gone through the IRS audit over just this topic. Independents are more cost effective than employees. Employees you can exercise more controls over. However, again, as stated prior, the IRS is looking hard at independents...they need income. Just some key points: Independents should be just that. You hire a painter to paint your house. You expect that they have the expertise and know how to accomplish that work. You don't need to manage them or guide them. You hire them to get the job done. An employee you develop, mentor, engage with, work with. An employee you have all employment issues to handle. Very different than Independent Contractor. Also, you provide benefits to employees, and not independents. If you use an Independent consistently and for a long period of time, this is flag to IRS as well. If independent does a lot of work for you consistently, it reflects more as an employee than an independent. If you are dependent on this for your company, if it's part of the functions of your agency and you HAVE to have this component...independents are looked at as an employee. Also, if the independent feels that they are an intricate part of the company, they may feel they are entitled to employee benefits and they may report your agency to the IRS and then you can be sure to have them knocking on your door requesting an audit. There is a 20 point check list on the IRS website that notes guidelines for what is an employee vs contract labor. Please be warned, however, that the guidelines are just that. If the IRS finds anything, I mean ANYTHING, that they see which appears to them that the contract labor should be an employee, that's how it will be ruled. Consequences can be big. Sorry, I could go on and on....your question brings up a bad memory! Simply stated, read all these posts....The IRS penalties are not worth the risk.

For inexplicable reasons, conventional wisdom mistakenly thinks a dollar spent via payroll is more expensive than a dollar spent via accounts payable. Yes, there may be additional costs of an employee, such as payroll taxes, retirement benefits, and sick/vacation time; but these should be factored into the cost comparison. Moreover, generally the contractor rate is higher than the salary in order to cover such additional factors and to give a premium for theoretically being subject to ceasing the contract at any given time. All the IRS issues have been described well by others and also must be accounted for in the financial comparison.

I certainly agree with everyone on this topic. In addition to the penalties you also need to factor in the impact of the audit itself. I speak from experience....we had to review payroll/AP records for 5 years retrospectively and refile all tax returns. Needless to say this was an incredible time drain on the staff and business. If in doubt, hire as employees!

I've been through an audit with the NYS DOL...

This process should be avoided at all costs because an audit is not fun and a significant time drain. The rules should be followed with respect to IC vs. employee classification. If in case of IC, I recommend clear guidelines (no work email, no equipment, no on-premise work, must have LLC...etc. for example).

Utilizing a healthy mix of IC/employee is great way to grow a business, but create rules (with help of your accountant) and stay discipline on rules....

Here is the IRS 20 Factor Test – Independent Contractor or Employee? http://www.appraisalinstitute.org/newsadvocacy/downloads/key_documents/IndependentContractorVsEmployee.PDF

The Government(s,) Federal AND State, want their payroll tax - that's the bottom line. Either the company pays, or the independent pays. If a company hires a contractor to do some work they are required to have a W-9 on hand where they can see the contracting company's EIN number.

The easiest gauge of whether someone is an employee is basically look at their income, if the vast majority of their income comes from your company - they're an employee.

Here is why it's important - If the IRS and the State deem that you misclassified an employee they will reach back and charge all the payroll taxes not collected plus interest, plus penalties. That entire amount owed is the responsibility of the owners of record of the company. If the company dissolves, sells, liquidates, whatever - the obligation follows the owner forever. You cannot get away from unpaid payroll tax. It will affect your personal FICO score, ability to borrow etc.

As mentioned above, this is low hanging fruit for the tax collectors, it's not worth the gamble.

With regard to the cost/ benefit of hiring an employee or an independent contractor (rather than the IRS risks) you may want to perform a risk analysis for the overall view and for each individual so that you can assign a monetary value to the issue (likelihood of the risk happening x value at stake) . If you don't have time to do this you may want to hire an independent contractor (like me) to do the analysis for you. Some factors to consider:

1. I work as an independent contractor so that I can make more money than I would as an employee not less.
2. factored into my charge-out rate is the amount of salary I want to make, the cost of administering my own office, the cost of holidays I want to take, the cost of the pension I need to save, the cost of training I need to attend (ie all the costs of an employee) PLUS a risk adjusted premium for how likely I am to get another contract sometime soon (ie a form of employment insurance). If you have "permanent" contractors make sure you get a discount for the number of hours they are working compared to the number of hours they might expect to be looking for a new contract.
3. A company is likely to hire me when they need something done urgently or in addition to the normal course of work (eg through the M&A process, large projects) with minimal supervision, training, or delays. They don't have to spend years waiting for me to get experience or training - I already have the skills required. This comes at a premium because of the value you have at stake and the value I bring. If you have repeat tasks, or work that is going to expand with the company you can take the time to grow an employee's competence rather than pay a premium for an expert.
4. I don't abuse my expenses but I also don't stay in Motels or eat at McD's: if you hire me as a contractor my travel to your office is at your expense not mine.
5. I make sure I document everything I do for a client and keep any work as simple as possible (eg make sure an Excel model can be understood by my successor) but there's always a risk that they will have to call me back if they can't work it out for themselves. The potential loss of knowledge can leave the client at risk: I have earned a fair bit of money tying up loose ends from other contractors. Though it's always possible an employee will leave after a short period, the risk is almost guaranteed with a contractor.
6. Internal controls and documentation may work against having a non-employee perform certain tasks. Some industries require all employees and contractors to be security vetted so a lot of turnover will cost a lot of money and lead to delays.
7. If an employee thinks of a new product or process whilst working for you it belongs to you: if I think of an innovative idea that would help you, I will sell it to you or your competitor at the highest auction price I can achieve (or keep it for myself).
8. If a project is halted, or an urgent need goes away, I can be let go without notice, without payment and without worrying employees who may fear that they will lose their jobs.
9. As a contractor, I want to move on to a new challenge even at the risk of not getting a new contract for some months: if your contractors want to stay for years they may not be very good at being contractors, or you're paying too much, or you may be such a great employer that they would work for you regardless of the price.

I hope you find some of these ideas useful.

Agree with the points made by everyone. In addition to potential fines/penalties, audit expenses, you may want to consider the intellectual property that walks out the door when the contractor leaves as part of the analysis.

I agree with everyone's comments. This is a real risk that needs to be carefully managed. There are appropriate uses for Independent Contractors, however it is best to outsource the classification. I have used a service, MBO Partners. There are others out there. After acknowledging the risk is real, I would recommend incorporating the following steps to then work through how to deal with it:

1. Understand long and short term human capital needs. Don't just look at the financial items (which can be large), but consider the impact to culture of having a large number of contractors vs. employees. Develop the right mix in conjunction with HR.

2. When looking for outside talent, use a third party to complete the classification. Few companies do business directly with individual 1099s. If an individual doesn't meet the requirements for a 1099, that third party can generally payroll the person (so they are an employee of the third party, which can mitigate the risk in the short term).

3. Develop a policy that governs how they are treated differently from employees during their time as a contractor, how long you can keep someone as a contractor, what happens when they meet those tenure limits, and what are the options to convert to an employee, can they come back, etc. Have exception rules built in. This alleviates having to make decisions on a case by case basis.

Our auditors tell me that unless the independent contractor has a valid and open UBI account with the state (Washington), I can't pay as a contractor. In addition to the W-9 I need a copy of their UBI in the file. This is stricter than the federal law. Other states may also have similar laws. Look on your state's Dept. of Revenue website to see what they say about it.

Thanks Patrick and yes I heard about two years ago that the IRS assigned/hired around 1300 people nationally to police this issue. Actually, I recently been contacted by a number of companies and/or by their CPAs looking for us to clean up the payroll/taxes for this year and on track going forward 2014 because the IRS discovered incorrect w-2/1099 classification "red flags".A few examples of these Red flags some of these small/medium sized businesses flew high for the IRS to see: converted longtime w-2 employees to 1099s, let go a few w-2s and hired replacements with same job description as 1099s (former employees might have blown the whistle) and another is owner incorrectly thought they could avoid paying high workers comp ins by classifying w-2 employees as 1099s and,of course, one of them was badly injured on the job and couldn't receive workers comp alerting the state.

I hope you are bringing your HR professional into this discussion, since that is one of the many areas for which you are paying him/her. As you already recognize, this question goes far beyond a financial consideration for your company in terms of potential liability. In fact, in the eyes of the IRS which really determines the categorization, not you, that is not part of the decision at all. The lists you have been given to use for the decision are the various factors which the IRS would consider to decide if this person is an employee or a contractor. Weighting depends on the circumstances, i.e. the final decision is more of an art than a science or checklist. Bottom line that all the factors considered together boil down to are, who is responsible for the process vs. the end product, and who incurs the risk of end product failure. E.g. if you provide the materials, tools, training, facilities, set the hours, require interim reports, pay by time, etc., you control the process and this is an employee. You incur the risk of failure to complete, since the employee was paid for what they did, right or wrong. If the person provides his/her own tools, skills/knowledge, works at their own location, sets the hours expected to be required to accomplish the contracted product, bids and works by the project, advertises to and works for multiple entities, etc. it is a contractor. They are responsible for the process, and producing the end result within the time, cost, scope and budget for which they contracted. While you cannot make this decision on the back end, you can have a large degree of control on the front end as to how you structure the work to meet the requirements of the preferred worker category. If you decide you really, really do not want the employee category, but cannot support this as a legitimate contractor, find a PEO or temporary help firm to take on the person as the employee and contract back to do your work. Hopefully, looking at the question through this lens will help.

Add to your risk profile "what happens if this goes terribly wrong?"
Example: an "independent contractor" works at your site, and slips on the proverbial banana peel. Normally, worker's comp would cover this, but in this case it the person doesn't have the required insurance. Your contract with them states that they are responsible for insurances, but you haven't checked to make sure they have them. So, instead of saving a few bucks, you get sued by the state.

The audits are a huge cost, the penalties are significant, and all it takes is one disgruntled "contractor" to bring the house of cards down. In that case you end up (often) out of pocket for the value of the benefits that you didn't give them, plus all the liabilities, plus the penalties, plus the audits (probably multiple), plus lawsuits.

This is an ongoing battle against those who want to "pick up pennies in front of a steamroller". Yes, it is likely a cash benefit...until you get squished.

Work with an agency to get contractors or payroll them out through the agency. It will cost you a bit more, but it reduces your risk and you can increase and decrease contractors based on your needs. Part-timing them would be another thing to consider on your payroll.

Robin raises a good point. In some companies, their budgeting process makes it hard to hire a full-time employee, with benefits. But the same company lumps contractors's cost into a less noticeable bucket. So the managers may use the contractors for a long time, even if they are more expensive. Generally speaking, when doing a project with a definite end, use contractors (think movies - the actors, the writers, the crew, all contractors). When you have several smaller, ongoing tasks, especially requiring supervision, hire employees. Staffing agengy temps - sort of a middle ground.

Good discussion. Would you say this applies to a health care facility contracting with a specialist to provide services at the facility? Days, hours and location are all set and office staff make the appointments, all of which is suggestive of an employment relationship. However, the specialist has his/her own practice. Are there special industry-specific rules?

If you are looking for back up to support your argument, make the IRS the heavy hitter and ask them. There is a simple form and they provide a ruling:
http://www.irs.gov/pub/irs-pdf/fss8.pdf

Another thought is to check with your state's workman's comp office. They set a definition of employee vs contractor that may be different from the IRS for tax purposes. You should abide by their ruling and definitions, not making up your own.

I have not read the prior answers so not sure if you have already covered this. The contractor vs employee conversation is a good one.

Look to your STATE's independent contractor defintions and what are the some 10 indicators your STATE will accept as evidence that you are able to utilize contractors. The Federal rules are required to be followed for tax purposes and reporting and they are easy to violate. Your STATE has rules that must be followed before you start worrying about FEDERAL rules. FEDERAL rules apply all the time but the FEDERAL definition of Independent Contractor is contingent on the STATE Definition of Contractor.

If your company cannot meet the STATE Definition, you don't have to worry about the FEDERAL rules, you will be in violation of both.

Find out which agency in your STATE that defines Independent Contractor. If you are not able to fit that worker in to that definition, you have an employee situation regardless of the FEDERAL tax requirements.

Hope that helps. Your STATE will have a specific checklist to evaluate and it is easy to obtain, either via website or phone call and your HR dept will know how to obtain it.

There was a reference to state unemployment and while not recognized by many companies the state unemployment agencies can actually charge/receive unemployment taxes on your independent contractors - of course as public accountant we do not offer them up as such but I have had a client audited on just that.

The same is true of workers compensation - if the independent contractor does not carry their own workers comp then the company is required to pay it on their behalf. When I can - I never let a client work directly with a WC auditor because they tend to give the auditor much more information than they need and in the end, getting themselves in trouble.

My last comment would be for those that are being treated as independent contractors - while enjoying all the money along the way - hit the roof come tax time when they see the additional taxes they owe. If they feel that they have been misclassified, the IRS has made it very easy for them to appeal. When this happens guess what - the IRS is going to audit your payroll and contractors and we know what the outcome of that would be.

As a CPA who serves as the part-time CFO for several small companies, let me give it to you straight: ANY employer who's having a 'robust debate' about contractors vs. employees should take up cordless bungee-jumping. It's less risky. There is material all over the IRS website about how to draw that line. Treating an employee as an IC just because the employee said he was is NO EXCUSE. It is the employer's job to make that determination.

If the answer to any ONE of the following questions is "No," a company had better be treating that individual as an employee with a W-2:

1. Does the individual perform billable services to other companies?

2. Does the individual have an EIN that is different from his/her social-security #?

3. Does the individual provide his/her own work tools (e.g., laptop, etc.)?

4. Does the individual control when s/he does the work the company requires?

5. Does the individual have a separate business-type bank account?

6. Is the payee for this individual's work an LLC registered as such with the state?

To be sure, there are some gray area that a knowledgeable employer can deploy to ward off IRS visits. But that's a much longer and nuanced discussion. Anyone who thinks payroll taxes are expensive hasn't gotten nailed treating someone who really is an employee as a contractor. If/when the IRS finds out, the penalties are about 100%, there's interest on top of that. . .and the IRS won't negotiate a dime of it. Moreover, anyone who is an authorized signer on the bank account that issued the checks to a 'contractor' who is, in fact, an employee is PERSONALLY LIABLE for the unpaid taxes, penalties, and interest if the company cannot pay them.

Taking prudent risks is one thing. Stepping over this line isn't a calculated risk. It's just plain stupid. We've never done it because we know better. But we've seen companies that did, despite our strong written admonitions to the contrary, and then they got nailed. It's an ugly and expensive spectacle. Besides, someone shouldn't complain about the federal deficit if/when s/he is knowingly contributing to it through dimwitted and reckless activity. That individual is an industrial-strength hypocrite.