Contracting out work to independent contractors is another staffing option to consider, due to the many tax and non-tax benefits involved. However, the distinction between employee and independent contractor can be hazy, and misclassification can have serious consequences.
Advantages of Using Independent Contractors Classifying a worker as an independent contractor has distinct advantages for a company. Because many labor and employment laws are triggered only when a business reaches a certain size, keeping the number of actual employees on the payroll low may avoid liability. In addition, there are many up-front financial savings:
No employer contribution to workers' compensation insurance or unemployment
No employer liability for Social Security or Medicare taxes
No need to provide job benefits, e.g., health insurance, retirement plan
Disadvantages of Using Independent Contractors The most important disadvantage of using independent contractors is the danger of misclassification. Due to the inherent tax consequences, the IRS polices this classification diligently, and misclassification can result in an audit of the entire workforce. To further complicate matters, there are two different "tests" for independent contractors, one under the Fair Labor Standards Act [FLSA] and a 20-point IRS test. Meeting the criteria necessary to fulfill the independent contractor definition can be disadvantageous:
Less Control -- Perhaps the most influential factor in defining a worker as an independent contractor is that the worker controls the means and manner of reaching the intended goal. Accordingly, by contracting out, an employer gives up direct supervisory control over a given project.
Lack of Loyalty -- Another important defining element of the independent contractor is that he or she offers services to the public at large, not just to a single employer. Being one of several employers dealing with a single contractor may not provide your business with the same commitment in time and effort as might be achieved using permanent employees.
Need to Renegotiate Contracts -- The relationship between employer and independent contractor ends upon completion of the contract. Any further dealings with the same contractors require a new contract -- leaving the company vulnerable to raised costs.