5 Risks of Hiring an Independent Contractor

What you should be aware of when hiring an Independent Contractor

 

Hiring an independent contractor these days is like a no-brainer, right?

Especially when you start thinking about the cost-effectiveness, the ocean of diverse talent and skills readily available to you, and the ability for your business to take on short-term projects without long-term commitment.

Hiring independent contractors may seem like a win, win solution. Well, I don’t mean to burst your bubble, but it is our obligation to make you sure you know that while there are many benefits to hiring an independent contractor, it’s not all a bed of roses.

You see, like all good things, there are risks that you will need to weigh before hiring the next independent contractor.

We wouldn’t want you to dive headfirst into the pool of independent contractors before I tell you that you may be entering shark-infested water.

This is why we’ve compiled a list of 5 risks that you, as a small-business owner, should be aware of when hiring a freelance contractor.

But before we get into that, it’s important to know what independent contractors actually are. You may also hear them being referred to as 1099 workers, self-employed contractors, freelancers, contingent workers, or contract workers.

Here’s the thing though, many countries have different definitions of what an independent contractor is.

To stay on the safe side, check the labor laws of the country where your business is operating.

For the sake of simplicity in this post, think of an independent contractor as anyone who provides goods or services as a representative of your business as a non-employee.

Be aware that there are some very…and I mean very, important distinctions between independent contractors and employees. Understanding these differences, and implementing them correctly, could save you from a load of headaches.

This brings us swiftly to risk number 1:

1.   Worker Lawsuits

Did you just shudder? Because I sure did over here.

The scary part is that this scenario happens more often to small business owners than you might think.

How?

Picture this…

One day, your independent contractor could stop and think, “huh, I should be considered an employee…why am I not receiving any employee benefits?”

Take my friend named Barbara Business-Owner as an example. About a year ago, she hired Frank Freelancer – a freelance web designer.

The problem was that Barbara had Frank take on regular projects, which took up a lot of his time. As a result, he could no longer exercise his right to financial control as an independent worker to take on more clients.

Frank was not classified as an employee so he wasn’t entitled to any of the employee benefits such as health insurance, overtime, or vacation days.

So Frank filed a lawsuit against Barbara Business-Owner.

And spoiler alert…

Barbara lost the lawsuit– even after a very costly trial.

The legal process proved that Barbara was violating labor laws by not properly classifying Frank as an employee and providing him with employee benefits.

While this may not be the most common risk, it’s never a bad idea to have open and clear conversations with your workers about their classification to avoid incidents like this.

 

2.   Independent Contractors Filing for Unemployment

When someone who is registered as an independent contractor files for unemployment, the people down at the unemployment office raise their eyebrows in confusion.

Independent contractors are legal business entities. As such, they are responsible for their own finances, which they obtain through clients.

Storm clouds start to form when an independent contractor files for unemployment and lists your business as their employer.

Let’s say Frank Freelancer files for unemployment and lists Barbara Business-Owner as his employer.

The unemployment office doesn’t find a tax account for Frank Freelancer as Barbara Business-Owner never paid into this fund.

Now they will ask themselves why is Frank Freelancer filing for unemployment?

If he was truly an independent contractor, he would have multiple clients and therefore multiple sources of income and not file an unemployment claim.

The unemployment office will conclude that Frank Freelancer should have been classified as an employee and given the rights and benefits that come with that status. This includes unemployment insurance.

As a result, the unemployment office will then investigate whether Barbara Business-Owner was in violation of workers’ rights and protection regulations by misclassification.

Subjecting her to a full-blown audit.

3.   Improper Tax Filings Causing IRS Audits

“So what would happen if an independent contractor…oh, I don’t know… tried to pull a fast one over the IRS?”

Have you ever seen those movies or TV shows where the IRS burst through office doors, fisting all the paper they can get their hands on, shoving conglomerate owners, and strutting into their black vans in silence?

Well…it’s unlikely to be that dramatic but you may be audited by local, state or federal regulatory or taxing agencies if they have reason to believe that you should have been collecting and submitting employment taxes.

Even if you file your taxes correctly, if your independent contractor does not file their taxes properly, then your business may be audited.

And, you already know I’m bringing back Barbara Business Owner.

Sadly, this situation happened to her.

So Barbara was living happily–enjoying the web development services Frank Freelancer was providing for her law firm.

Unbeknownst to Barbara, Frank Freelancer under-reported his income so he could pay less contractor taxes. This discrepancy got flagged up by the IRS during their review process.

The IRS then investigated Barbara Business Owner!

The IRS wanted to determine if Barbara had fulfilled her obligations, such as issuing a form 1099, or if she had been withholding taxes.

This is a common occurrence. In fact, many business owners have come to me after being audited by the IRS because of their independent contractors’ tax mistakes.

4.   Lack of Business Insurance

Now, I don’t mean to scare you. However, if you hire an independent contractor who does not have the correct insurance, you may be on the hook for any legal claims that may occur.

If the uninsured independent contractor you hire causes an accident or damages any property, creates an error or omission, your business can be held 100% liable for any costs incurred.

Let’s say Barbara Business-Owner hired Frank Freelancer as an independent contractor.

Barbara assumed Frank Freelancer had business insurance but if any legal matters were to come up and Frank is not insured, it won’t take long for the party seeking damages to turn their attention to Barabra and her insurance.

So now, Barbara Business-Owner may be responsible to pay out of her own pocket or rely on her insurance, if they would even cover it, – no matter what that does to her premiums.

As shocking as it may seem, if an uninsured independent contractor makes a mistake, you could be held liable–leaving you, like Barbara, paying for damages even though you didn’t do anything wrong.

5.   Misclassification

Okay, we’re at the last hurdle now.

I touched on this briefly when talking about workers lawsuits and independent contractors filing for unemployment.

Both of those risks are an extension of misclassification, which is a major risk of getting audited.

It’s very important to understand the difference between an independent contractor and an employee. They are very distinct worker classifications that have different rights and responsibilities.

If the lines between whether your worker is classified as an employee or independent contractor get blurry, then you are more than likely misclassifying your worker.

“Misclassification this… misclassification that. Why does it matter?”, you ask.

Well, because worker misclassification puts your business at risk for fines, penalties, tax sanctions, and audits.

Understanding that employees and independent contractors have different levels of financial control, and behavioral control is a good starting point to know how to correctly classify your workers.

How can you avoid these risks?

While this blog post may be… nerve-wracking… its purpose is not to tell you to avoid independent contractors as though they were some sort of horrific plague of the ‘black death’.

Rather, understanding and adhering to guidelines will allow you to ensure a mutually beneficial relationship that abides by the law, protects you and your workers, and maintains the integrity of the freelance model.

Understanding the difference between employees and freelancers, knowing how to properly classify your workers, understanding potential tax triggers, and –most importantly– consulting a professional will help mitigate the risks of hiring independent contractors.

 

ClearPath is a leading Human Resources Outsourcing company focusing on the contingent labor market. We’re committed to helping business owners stay compliant and minimize the risks associated with their contingent labor requirements. Contact us today to make an appointment.

 

No Legal Advice Intended. This article includes general information about legal issues and developments in the law. Such materials are for informational purposes only and may not reflect the most current legal developments. These informational materials are not intended, and must not be taken, as legal advice on any particular set of facts or circumstances. You need to contact a lawyer licensed in your jurisdiction for advice on specific legal issues.