When someone performs services for a business, he may be deemed an employee or an independent contractor. The differences between the two are highly significant, as explained below.

The small business owner should use independent contractors, rather than employees, whenever possible. The use of independent contractors, rather than employees, is one of the most effective asset protection tools because the employer:

• is not liable for torts committed by an independent contractor he employs, as the doctrine of respondeat superior does not apply to independent contractors; this fact is in stark contrast to the law that applies to torts committed by employees, and makes the use of independent contractors a singularly effective tool in eliminating tort liability that otherwise would apply against the limited liability company (LLC) or corporation
• is not required to pay employment taxes (Social Security and Medicare tax as well as unemployment tax) or worker's compensation insurance on the wages paid to independent contractors and, similarly, is not required to withhold federal income taxes for the wages paid; the employer only pays the independent contractor his gross wages and, at the end of the year for each independent contractor paid $600 or more, sends the independent contractor and the IRS a Form 1099-MISC showing the gross wages paid

An additional benefit is that the law does not require that independent contractors participate in any retirement plan offered by the employer. In contrast, anti-discrimination rules usually mean all employees must be covered by an employer-sponsored retirement plan.

Work Smart Nothing prevents a business from voluntarily including independent contractors in a retirement plan. While doing this will involve additional costs, it also may sufficiently appease workers enough to avoid worker challenges to their independent contractor status. The employment tax and tort liability savings may outweigh the costs of including these workers in the retirement plan. Of course, as discussed below, a misclassification can come to light in other ways, such as during an IRS audit.

The employment tax savings alone warrant the use of independent contractors. When the employer uses employees, rather than independent contractors, the Social Security and Medicare taxes paid by the employer amount to 7.65 percent of wages paid. Federal and state unemployment taxes typically average 0.8 percent of wages. This, of course, is in addition to unemployment insurance, which can be quite costly in many businesses.

In addition, recordkeeping is simplified, because no withholding from wages or employer tax reports are necessary. As a result, the small business owner normally will not need a payroll service, which will produce still more savings.

Nevertheless, the tax savings pale in comparison to the elimination of the business's tort liability.

Warning Independent contractors are self-employed. In essence, they are operating their own business (usually as sole proprietors). Accordingly, they report their wages on Schedule C of IRS Form 1040, pay their own Social Security and Medicare taxes (termed a self-employment tax), and file their own estimated taxes in quarterly reports. The self-employment tax, before any reductions, amounts to 15.3 percent. Because of the steep self-employment tax and the additional recordkeeping that will be required, many workers will object to independent contractor status and insist on being deemed employees. Workers also may object to independent contractor status because they want to participate in the business's retirement plan.

A small business owner can choose to use independent contractors, but their ultimate classification as such is not up to the employer. Strict rules must be followed so workers are properly deemed as independent contractors. A good place to start is with a written employment agreement, which clearly labels the worker as an independent contractor.

However, labels will not control the outcome. The law (both tax law and agency law) has developed elaborate rules that control whether a particular worker is properly classified as an independent contractor. If the worker does not meet these tests, the label will mean nothing. The worker will be re-classified by the courts or the IRS as an employee. If this happens, the small business owner can expect a bill for back employment taxes, with interest and penalties, or an unfavorable outcome in a tort lawsuit.

Warning Be careful about mislabeling workers. Because of the significant payroll tax advantages to using independent contractors, the IRS targets misclassifications when it audits small businesses. Another instance when a misclassification may come to light is when a worker commits a tort and the injured party seeks to sue the LLC or corporation under the doctrine of respondeat superior. Here, the misclassification is at least worth a try. If the suit is lost, the result is no worse than if the worker had been properly classified in the first place. Overall, however, the risks associated with an IRS audit may outweigh the benefits realized here.

Independent Contractor Legal Guidelines. Over the years, the courts have developed approximately 20 factors in testing whether workers are properly classified as independent contractors or employees. For the most part, the IRS follows the same guidelines. Many of these factors can be condensed into one factor--control. What follows is a comparison of the two forms of employment, in terms of this factor.

Unfortunately, cases will usually turn on the peculiar facts of each particular employment situation.

Warning The following three examples were taken from actual tax court cases: Bicycle assembly workers were deemed employees even though they brought their own tools to work, furnished their own transportation to sites, and were largely unsupervised at sites because the employer had absolute control over the workers in terms of directing their rate of pay, working hours, assignments, etc., and prohibiting them from working for competitors. Telephone company solicitors who worked on the premises of the telephone company were deemed employees, but solicitors who worked at home were deemed independent contractors because they provided their own "tools of the trade." Associate physicians at a hospital were deemed employees because the hospital could fire them if they did not meet hospital standards, thus indicating that the hospital had control over the physicians.

Be sure to check all 20 factors in the IRS test before attempting to use independent contractors. If there's any doubt, consult a legal professional.

IRS Section 530 Independent Contractor Safe Harbor Rule. In 1978, the Internal Revenue Code was amended to provide a so-called safe harbor for employers interested in using independent contractors. Note that this safe harbor will apply only in tax cases and should have no bearing in a tort case where the plaintiff is seeking to hold the employer accountable under respondeat superior. Further, under the safe harbor rule, employers remain liable to contribute to retirement plans, and are still required to withhold income tax and Social Security tax from employees' wages.

The small business owner should attempt to fit his use of independent contractors into the confines of the IRS Section 530 safe harbor. To do so, the employer must prove two things, that the owner: did not, ever, classify this worker, or any similar workers, as employees had a reasonable basis for classifying the worker as an independent contractor, either because of the common law tests or because a significant segment of the industry (usually 20 percent, but perhaps as low as 18 percent) has treated workers of this type as independent contractors for a long period of time (generally, at least 10 years). Section 530 is not available when the worker provides services as an engineer, designer, drafter, computer programmer, systems analyst or any similar line of work.

In 1996, the Section 530 safe harbor was amended to allow business owners to shift the burden of proof in cases to the IRS. Effective January 1, 1997, the employer, by showing any reasonable grounds were relied on in classifying the worker, can shift the burden to the IRS to disprove independent contractor status. Unless the IRS can do this, the classification is presumed to be valid. This modification was designed to codify an earlier court ruling. It is regarded as establishing a relatively low burden of proof for employers.

Temporary employees. Until recently, the use of "temps" from an employment agency was considered another type of safe harbor. It was thought these workers could always be classified as independent contractors. However, in 1998 and 1999, court decisions clearly established that this is not a safe harbor.

In many cases, temporary workers are considered employees of the temp agencies that hire them. It also was thought that workers could only have one employer and that, accordingly, if temp workers were employees of the temp agency, then they could not be employees of the companies to which they were assigned. Thus, they must necessarily be independent contractors at the companies where they actually work. In these cases, the courts rejected this argument.

According to the courts, for tax purposes, workers may have two employers and be considered employees of both the temp agency and the company to which they are assigned.

In short, with respect to temp agency workers, the regular common law 20-factor test or the Section 530 safe harbor rules will apply.

Independent Contractor Exceptions. In tort cases, contrary to the general rule, courts may hold an employer liable for the acts of his independent contractor when:

• the employer has a legal duty that may not be delegated to another (such as the duty of an apartment building owner to maintain the premises in a safe condition)
• the activities involved are abnormally dangerous (such as using dynamite)
• the employer was negligent in hiring the independent contractor and, thus, committed a separate tort

Further, in contrast to the safe harbor rules, the IRS has special exceptions that govern independent contractor status for certain workers. These workers are automatically, for tax purposes only, deemed to be statutory employees.

These rules include an employer's workers who are:

• independent drivers who deliver beverages (other than milk), meats, vegetables, fruits, bakery products, or laundry or dry cleaning
• sales workers who call on hotels and restaurants
• home workers who perform work in their own home or the homes of others and are paid more than $100 during the year
• full-time life insurance salespersons

The employer, in each case, must withhold and match the required Social Security and Medicare taxes, as would be done for any other employee, but is not required to withhold income taxes from the employee's wages. Finally, except for full-time life insurance salespersons, statutory employees like independent contractors may be excluded from employee retirement plans.