• If an employer works with an independent contractor, they need to define the nature of the employment relationship under the regulations of several agencies.
• Various state and federal agencies have different criteria for distinguishing between employees and independent contractors.
• Employers that work with independent contractors aren't required to pay for unemployment insurance or workers compensation, and they don’t need to withhold state income tax.

Working with independent contractors involves a number of responsibilities for the host employer. These range from ensuring the safety of both parties’ employees to verifying the employment relationship for purposes of taxes and benefits. Both federal and state laws often govern and enforce independent contractor classification issues.

Employee vs. independent contractor

When hiring an independent contractor, a company should define the nature of the employment relationship under the regulations of several agencies. These include:

• The Internal Revenue Service,
• State unemployment compensation agencies,
• State workers’ compensation agencies,
• State tax agencies, and
• The U.S. Department of Labor.

Each agency has different criteria for distinguishing between “employees” and “independent contractors.” This distinction is important because the classification determines employers' rights and responsibilities. Employers must handle independent contractors differently than other employees. Independent contractors, for example, aren't subject to the minimum wage and overtime requirements of the Fair Labor Standards Act (FLSA).

Employers should note that different agencies might use different criteria when defining employment relationships. Thus, what one agency defines as an independent contractor relationship could be defined by another agency as an employer/employee relationship.

The Department of Labor

FLSA: Employee vs. independent contractor

A worker’s classification as an employee or an independent contractor makes a significant difference when it comes to their rights under the FLSA.

The FLSA includes provisions that require covered employers to pay employees at least the federal minimum wage for every hour they work and provide overtime pay at no less than one-and-one-half times their regular rate of pay for every hour over 40 worked in a workweek. FLSA protections don't apply to independent contractors.

The Internal Revenue Service

Employers generally don't have to withhold or pay any taxes on payments to independent contractors when it comes to the Internal Revenue Service (IRS). Instead, the company must issue an IRS Form 1099 to the contractor at the end of the calendar year. If an employee is incorrectly classified as an independent contractor, however, the company can be held liable as an employer for taxes, plus any interest or penalties. In determining whether the person providing services is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

State unemployment compensation

Employers aren't required to pay for unemployment insurance for independent contractors. Different agencies, however, use different criteria to define an employment relationship. For example, the IRS might define a business arrangement as an independent contractor relationship, while the state unemployment insurance agency may define it as an employer/employee relationship. The same workers can be considered “independent contractors” by one agency and considered “employees” by another agency.

Employers should always consult the state unemployment insurance agency or seek legal counsel to ensure proper compliance. Employers must understand precisely how the relationship is defined before hiring an independent contractor. Clarifying the relationship avoids situations like an ineligible independent contractor mistakenly applying for unemployment compensation, thus inviting an audit by the unemployment agency.

State workers’ compensation

Employers aren't required to purchase workers’ compensation insurance to cover independent contractors. However, most employers must provide workers’ compensation insurance for employees as defined by the applicable laws, even if those workers are considered independent contractors by other agencies.

State workers’ compensation agencies may consider factors that aren't accounted for under the IRS criteria. These may include an expectation for the alleged contractor to have one or more bank accounts in a business name, to be paid in a business name, or to have a Federal Employer Identification Number (or FEIN) rather than simply a Social Security number.

Employers should keep in mind that individuals covered by workers’ compensation normally may not sue their employer for injuries that occur on the job, but that's not always the case for independent contractors.

State tax agency

Employers don't need to withhold state income tax from payments made to independent contractors. State tax agencies may use different tests to define the employment relationship, so employers should always consult the state tax board or their legal representatives to ensure proper compliance.