What Is An Independent Contractor? Part I
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What Is An Independent Contractor? Part I

Probably the most basic question in the employment context is whether a worker is an employee or an independent contractor.

By Johnny Duncan

This article is divided into three parts. Part one will examine the definition of an independent contractor as well as the costs and benefits of hiring an independent contractor. Part two and three will explore the risks involved in hiring an independent contractor and the various tests used to determine if the individual is an independent contractor or employee.

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  • 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. Independent contractors (ICs) are often described as persons engaged in occupations who contract to perform work according to their own methods, and with the exception of the end result, are not subject to control of the employer. In spite of the facial clarity of these descriptions, it is often difficult to provide a precise definition of an IC that is adequately specific, and at the same time, encompassing enough to apply to all the factual situations that may arise. It is because of this lack of a clear-cut description that it is necessary to study the various factors considered by governmental agencies in determining whether an individual is an employee or an independent contractor.

    Benefits of Being an Independent Contractor
    When a person decides to become an independent contractor, they essentially become their own boss, along with all the risks and rewards that entails. Most ICs enjoy the freedom that comes from being in business for themselves. They consider themselves master of their economic fate because the amount of money they make is directly related to the quantity and quality of their output. ICs are not dependent upon a single company for their livelihood and the hiring and firing decisions of any one firm does not have the impact on them as they have on employees.

    Independent contractors typically earn more money than an employee doing similar work. According to the Wall Street Journal, ICs are generally paid at least 20% to 40% more per hour than employees performing the same work. Of course, this is because hiring firms don’t have to pay half of the IC’s Social Security taxes, pay unemployment compensation taxes, provide workers’ compensation coverage or other employee benefits such as health insurance and sick leave. Even with the IC paying taxes and benefits themselves, they can still earn more per hour than regular employees through creative marketing and negotiations.

    Another benefit of being an independent contractor is having more control of money earned because of the many tax benefits. No federal or state taxes are withheld from IC’s paychecks as they must be for employees. Instead, ICs ordinarily pay estimated taxes directly to the IRS four times a year. This means that the earned income can stay in the IC’s hands longer and result in an improved cash flow over regular employees. The IC also has the advantage of many business-related tax deductions that are restricted or not available at all to employees. These may include office expenses including those for home offices, travel expenses, equipment and insurance costs, and entertainment and meal expenses. ICs can also institute tax advantage retirement plans such as Keogh Plans and SEP-IRAs. This will provide the means for them to shelter a substantial amount of their income until they retire. Because ICs can have these tax benefits, they often pay less tax than employees who earn similar incomes.

    Costs of Being an Independent Contractor
    The independent contractor has no job security. As an employee, the worker is paid as long as he or she has the job, even if the employer’s business is slow. This is not the case when the worker is an IC. If the IC does not have the business, they do not make any money.

    The IC also has no employer-provided benefits. Employers will usually provide their employees with health insurance, paid sick leave and paid vacations. ICs get no such benefits. They must pay for their own health insurance, often at higher rates than employers are able to pay. Any time lost due to vacations and illness comes directly out of the IC’s bottom line. Retirement must also be funded by the IC. The safety net provided by unemployment insurance is not there for the IC either. They cannot collect unemployment when the work for the client is terminated or the contract runs out. Finally, the benefit of employer-provided workers’ compensation is not there for the IC. If a work-related injury is an IC’s fault, he or she has no recourse against the hiring firm.

    Independent contractors run the risk of not being paid by the client. Employees normally have no problem being paid on time by their employers, but ICs bear the risk of loss from deadbeat clients. This lack of payment also affects the personal liability for business debts. Employees are not liable for the debts incurred by their employers. An employee may lose his or her job when the employer’s business fails, but will not owe anything to the employer’s creditors. However, an IC whose business fails could lose most of what he or she owns. The potential for loss business for the IC because of discrimination is another risk factor to consider. Few or none of the extensive federal and state laws that protect employees from unfair mistreatment and discrimination by employers apply to ICs.

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    Benefits to Firms for Hiring Independent Contractors
    Businesses can usually save money by hiring ICs in place of employees. Along with paying salaries or other compensation, employers usually must pay other employee expenses such as:

    • Workers’ compensation insurance premiums
    • State unemployment insurance premiums
    • Federal payroll taxes, including Social Security tax and federal unemployment insurance tax
    • Employee benefits such as health insurance, paid vacations, retirement benefits and life and/or disability insurance, and sick leave
    • Office space and equipment
    These expenses can add at least 25% to 45% to payroll costs. Firms incur none of these expenses when they hire an IC. ICs may get paid more per hour than employees doing the same work, but they still cost less in the long run.

    Another benefit to firms hiring ICs is that the exposure to some lawsuits such as those alleging wrongful termination and job discrimination is reduced. Some ICs who have brought lawsuits against firms alleging discrimination under Title VII have loss their case in courts using the Discrimination Test (a hybrid test using a combination of "control" and "economic realities" tests discussed later in this paper) to decide the correct classification of the worker.

    At last, probably the most important for many firms is that ICs provide flexibility that can not be achieved with employees. ICs are paid to accomplish only a specific task, allowing the firm to get specialized expertise in a short time frame. An experienced IC can be productive instantly, eliminating the money and time needed to train employees.

    In our next issue, we will explore the risks involved in hiring independent contractors as well as a few of the tests used by different agencies to determine the correct classification of a worker.

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