Should You Hire Employees or Independent Contractors?

Executive directors (EDs) pay careful attention to their labor costs. They hire employees to fill key positions, and leverage independent contractors to address time-bound projects, busy periods, planned and unplanned absences, and specialty needs (e.g., grant writing, bookkeeping). Use of contractors saves the hard dollar costs associated with payroll taxes, payroll administration, workers compensation insurance, and employee benefits. It gives EDs the flexibility to align labor costs with projected funding for the fiscal year. And it provides a degree of agility in managing expenses when actual funding falls short of expectation.

However, misclassifying employees could subject a nonprofit organization to significant financial and business risk. Would-be employees dubbed “contractors” could file suit. Governmental agencies could assess fines and penalties. Federal and state grants could be called into question. Insurers could deny access to coverage. And the tax status of the employee benefit plans could be placed in jeopardy.

The IRS uses three broad categories of factors to assess an individual’s employment standing within an organization: behavioral, financial, and relationship between the parties.

Broadly, in the case of an employee, an employer has the right to tell the worker what to do and how to do it. The latter includes what work the individual must do (versus delegate to others), what tools or equipment to use, what sequence to follow, where and how to purchase supplies and services, and where to perform the work. In an independent contractor relationship, an employer can specify the desired outcome for the work but not the method of performing services. That being said, there are a number of factors that the IRS will consider when making its final determination.

Independent contractors typically invest in the tools they use to perform work (e.g., furniture, office equipment, computers, software) for which they are not reimbursed directly by clients. They usually make their services available to other organizations in the relevant market. They tend to be paid on a flat-fee or time-and-materials basis versus receiving a specified wage. An independent may make a profit or loss on the business.

An independent contractor arrangement tends to be characterized by a contractual relationship that specifies the nature of the work, the time frame allotted for completion, payment for services rendered, and any employee-type benefits offered. Note: If the worker will provide services that are central to the operation of the agency, then it increases the likelihood that you will control that individual’s work processes and output. In such cases, the presence of a signed contract will not overcome the weight of the behavioral factors that suggest an employee relationship.

If your assessment of a worker’s relationship suggests an independent contractor, here are 6 things you can do to assert your position:

1. Establish a written agreement stating the intent to have an independent contractor relationship.
2. Within the contract, grant as many freedoms to the independent contractor as possible, including the right to set working hours, hire assistants and work for multiple other businesses.
3. Set a fixed term with no (or limited) automatic renewal provisions.
4. Affirm the independent contractor’s responsibility to report the income and remit all federal and state employment taxes.
5. File all required 1099 forms.
6. Use classifications consistently across all workers.

There are many good business reasons to classify a worker as an independent contractor, and many cases when that classification is proper. If you mistakenly classify workers in good faith and are found liable for employment taxes, you may be able to get relief through what is known as the Section 530 “safe havens.” These provisions enable you to assert a reasonable basis for your treatment so long as you provide proof of the consistent classification of and reporting on individual workers and groups of workers.

Careful analysis and due diligence in partnership with your professional tax advisor are a good investment of time and money to protect your business from potential liability.