IRS Definition of Contractor

• IRS regulations define the difference between an employee and a contractor. To treat your employee as a contractor you must meet the conditions set out by the government. These regulations impose significant burdens on the changed relationship. Even if you and your employee agree on contractor status, the IRS can impose penalties if it makes the opposite determination.
  
  

Loss of Control

• A contractor performs his work in any manner that accomplishes the job, the IRS states. You cannot tell him how to do it, beyond general instructions. You cannot tell him when to report to work or how long to work. Generally, you do not control a contractor's pay rate per hour. Contractors receive pay for accomplishing a task. A contractor may also set his own pay rate.
  
  

Creating Your Competition

• A contractor generally holds himself out to the public for hire. Consider whether you want a former employee, well-versed in your services, products and rates, bidding against you. However, if you require a contractor to work for you exclusively, the IRS may use that to determine an employer-employee relationship. A noncompete clause in the contract may not help. Recently a Pennsylvania company lost an appeal while attempting to enforce a noncompete clause against a former employee hired as a contractor. The court ruled that an employer-employee relationship existed.
  
  

Tax Penalties

• The IRS imposes costly penalties on employers who intentionally misclassify employees as contractors. The IRS can require you to pay the full amount of Social Security and Medicare taxes due, both yours and the employee's, even if you did not withhold the employee share of tax. The IRS can require you to pay the employees federal income tax withholding, even if not withheld. State and local taxing authorities may assess additional unpaid employment taxes due. Additionally, expect the addition of interest and penalties to all amounts due
  
  

Legal Issues

• Workers compensation insurance covers employees not contractors. A contractor may sue your company if he is injured at your work site. Employees misclassified as contractors may also bring suits to recover lost insurance benefits, overtime pay, and retirement plans. Worse, a member of the public may sue you for the actions of someone deemed an employee, but not covered by your company liability policy.