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Whether you call them consultants, free-lancers or gurus, independent contractors can add experience and flexibility to your team while saving you money. By using contractors rather than employees, you can avoid payroll taxes, benefit costs and the threat of lawsuits under several federal laws covering safety and discrimination.

And it seems to be a win-win situation. Many workers are seeking the freedom to take on other clients or use flexible scheduling to help balance work and their personal lives.

More than 8 million people, about 6.3 percent of the work force, are independent contractors, according to a 1999 Bureau of Labor Statistics survey. A whopping 84 percent of them said they were satisfied with their work arrangements.

But when they try to claim unemployment benefits, sue for sexual harassment or look at their tax bill, some find that they've given up more than they expected.

There's a downside for you, too. If the worker or the IRS can show that you misclassified an employee as an independent, you can be on the hook for back taxes, interest, benefits and penalties.

Before calling someone an independent contractor, you need to make sure he passes multipart tests from the IRS, U.S. Labor Department and your state to determine whether that classification truly applies.

And don't skip the state tests, nearly two dozen states have more stringent regulations than the IRS. To make sure workers are really independent contractors, states generally want to see that a worker: 

  • Controls his work. 
  • Has an off-site workplace. 
  • Has an independent business. 

If it looks like a duck ...

Simply changing what you call a worker from employee to independent contractor, or rehiring former workers as contractors with the same responsibilities, is sure to raise a red flag before the IRS or in court.

Paying contractors the same way you pay employees and including them in benefits also raises skepticism about their independence.

The IRS looks at three main factors:

  • How much control does the employer exercise over the worker's behavior? Telling the worker when, where and how to perform the job weakens the argument that he is "independent."
  • What financial control does the employer have over the worker? The criteria here include whether the worker has unreimbursed business expenses and his opportunity for profit or loss. 
  • How do the worker and employer view their arrangement? A written contract is vital. The worker's availability to provide services for other businesses also weighs in favor of his being independent. 

One more tip: Even if your contractors are reclassified as employees, you might avoid back-payroll taxes if you were consistent in how you classified workers with similar jobs, had a "reasonable basis" for treating them as independent contractors and filed Form 1099s properly. The Form 1099s that you mail to contractors should be postmarked by Jan. 31 and include the phone number of a company contact.

Note: Some IRS auditors don't mention this so-called Section 530 relief when doing a classification audit. Demand that the auditor show you IRS Publication 1976, which explains how you can avoid paying back taxes.

For more information ...

You can ask the IRS to determine whether a worker qualifies as independent under federal tax law by filing Form SS-8, Determination of Employee Work Status. It's available online at www.fedworld.gov/pub/irs-pdf/fss8.pdf, or by calling (800) 829-1040.

IRS Publication 15-A, Employer's Supplemental Tax Guide, includes a section on deciding independent contractor status. Review it at www.fedworld.gov/pub/irs-pdf/p15a.pdf.

You and the Law offers a special report, Using Independent Contractors, (Publication N268). Cost: $24.95. To order, call us at (800) 543-2055.

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