Ask Rita: Can I Just Hire Independent Contractors?

Dear Rita in HR: I am executive director of a very small nonprofit. Recently, I had to fire an employee for the first time. In retrospect, I probably made a bad hiring decision, but it was a real nightmare to go through. I would like to just hire independent contractors from now on. As I understand it, with contractors I just pay them a flat amount every month and at the end of the year they get a 1099 instead of a W-2. Sounds like a great solution to me! Are you going to rain on my parade?

Signed,

Found the Magic Wand

Dear Magic Wand: Get out your umbrella, my friend. Payroll and other taxes can account for up to 30 percent of an employee's cost, so I understand how hiring an independent contractor instead of an employee can sound like a good solution for nonprofits on a tight budget. Unfortunately, the federal government and many states are cracking down on that practice, called "worker misclassification," and with good reason. Some employers have abused the independent contractor classification as a way to avoid paying minimum wage and payroll taxes or to duck requirements for meal and rest breaks. In 2010, the Massachusetts Attorney General settled a case with FedEx Ground alleging misclassification of its drivers as independent contractors. That settlement was worth $3.5 million. New York has a special task force devoted just to pursuing misclassification issues. California imposes stiff fines on employers for misclassification, above and beyond the other penalties that otherwise exist.

Don't think that your nonprofit will be immune because of your small size or 501(c)3 status. I have seen several nonprofits get caught in the misclassification trap after they terminated the "contract" and the worker subsequently filed for unemployment benefits, for which contractors are not normally eligible. Increased cooperation between governmental agencies means that information gets shared between all the different government entities that get a piece of those payroll taxes. So while it may start with an unemployment claim, it can lead to a full-scale audit of your organization by state and federal tax authorities.

So what is the legal definition of an independent contractor so you can avoid the misclassification trap? Ah, if only it were that simple. You see, different tests are used to determine whether a worker is properly classified depending on the agency reviewing the classification. The IRS has its own rules, but state workers' compensation, unemployment and labor boards also have their own regulations for classifying workers as independent contractors or employees.

Whether a worker is properly classified as an independent contractor or an employee is not something that an employer can just decide to do one way or another. The classification depends on the nature of the relationship. In general, your relationship with an independent contractor is going to be more like one you have with a separate business that is providing a service or product for a set price with little direction in how the work gets done. Not surprisingly, the more "independent" the worker, the more likely they are to be appropriately classified as a contractor.

The following chart explains the types of tests typically used by governmental agencies to determine whether someone is an independent contractor or an employee:

Type of Test

Common-law

Economic Realities

Hybrid

Description

Degree of control and degree of independence in three categories: 1) behavioral control; 2) financial control; and 3) the type of relationship. The origin of this test is in the twenty-factor IRS test (see links at the end of the article).

Often used where there may be multiple employers, this test focuses on whether the individual worker is economically dependent on the business.

The broadest test will look at both the economic realities and the common-law factors, particularly the right to control the "means and manner" of how the work is performed.

Agencies and Laws That Use This Test

Federal Insurance Contributions Act

Federal

Unemployment Tax Act

Income tax withholding

Employee Retirement and

Income Security Act

National Labor Relations Act

Immigration Reform and Control Act

Title VII of the Civil Rights Act

Age Discrimination in Employment Act

Americans with Disabilities Act

Fair Labor Standards Act

Family and Medical Leave Act (likely to apply)

Title VII of the Civil Rights Act

Age Discrimination in Employment Act

Americans with Disabilities Act

Courts in different areas of the country have applied the tests differently, and as you can see from the chart, some laws have been analyzed using more than one test. Now that we've gotten through the legal jargon, let's look at the problem from a more practical perspective.

Best Practices for Classifying Workers

Although every situation will be a little different, there are some common characteristics of a contractor relationship. For example, a contractor will typically:

  • Have a significant degree of control over how the work is performed (minimal direction by the employer)
  • Provide their own equipment for the work
  • Have multiple clients
  • Set their own hours
  • May hire and fire their own workers
  • Operate as a "business" including a bank account separate from their personal account, have a federal tax ID number, and their own insurance.

You should always have a written agreement with an independent contractor. This agreement should specifically state that they are not an employee and that they are responsible for their own payroll taxes. I strongly recommend that you require the contractor have his or her own insurance.

You should also avoid treating the contractor like an employee. For example, independent contractors should not receive the types of benefits that employees often receive, such as paid time off or health insurance. While employees may require job training, independent contractors should come to the job already having the necessary skills and training. Contractors should not be using your nonprofit's business cards, and if you give them an email address, consider using the word "contractor" in the address or specifying that the individual is a contractor in their signature line.

Using an independent contractor can be a great way to source work for a short-term project or work that requires specialized technical skills. Misclassifying a contractor can mean big dollars for your nonprofit, so march forward, but make sure you proceed with care.

For more information on federal rules on independent contractors, see below:

IRS Definition of Independent Contractor

https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Defined

IRS site on Contractors vs Employees for Exempt Organizations

https://www.irs.gov/Charities-&-Non-Profits/Exempt-Organizations:-Independent-Contractors-vs.-Employees

IRS Site: Independent Contractor or Employee?

https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee

Department of Labor Employee Misclassification Initiative

https://www.dol.gov/whd/workers/misclassification/

Small Business Administration

http://www.sba.gov/content/hire-contractor-or-employee

Siobhan Kelley is an Employment Risk Manager at the Nonprofits Insurance Alliance Group (the Group), a sponsor of both American Nonprofits and its magazine, Blue Avocado. Siobhan is one of the employees of the Group who provides free employment risk management consulting services to their member-insured nonprofits.

Comments (20)

  • Great response and spot on. It is scary how many non-profits and for-profits don't know this. You are right. States and the feds are getting serious about this because they want the FICA and the unemployment taxes.

    Jul 25, 2016
  • Thank you Scott!

    Jul 29, 2016
  • On the other hand, there are new models that are being developed where using independent contractors, or an agency, to do work normally associated with w-2 employment, and this can be very beneficial for small non-profits. The rules stated still apply, but in many instances, the pay off can be access to a much higher level of professional. For example, if a start-up has $30k in the budget for an executive director, it might be a better move to hire a consulting ED, sometimes called a strategist, that can help create operating, financial and marketing plans that will move your non profit leaps and bounds ahead of hiring someone with little to no experience. Check out Cultureworks in Philadelphia as an example of a very interesting new model. http://www.cultureworksphila.org/

    Jul 28, 2016
  • Thank you for your comment Christine, I think you bring up a really good point. There is phenomenal growth in using services provided third party to help fill the gaps in skills. Many people feel our labor laws are behind the curve on the new models of employment relationships. Both workers and employers increasingly desire a flexible relationship. As the average employment tenure decreases, it will be interesting to see how our employment laws adapt. Having said that, I could not recommend using a third party as an Executive Director. Employees should report to other employees, not to someone working as an independent consultant.
    Thanks for the link to Cultureworks. I have used coworking facilities myself and find the collaborative atmosphere great for nonprofits.

    Jul 29, 2016
  • Siobhan -

    Thanks for the reply re. CultureWorks. Just as a note, we do offer coworking as an amenity to our principal programs (COPILOT and TRUST), which are focused on shared human capital and other essential infrastructure: HR, legal, finance, compliance, fundraising, marketing, advisory services etc. These are the program resources at the center of our theory of change. Unfortunately, the rage around coworking tends to catch people's eye more than our shared services. While coworking is a nice amenity, I think it's not as productive of organizational capacity as the coworking marketing hype would have you believe. It's nice model for space sharing, but space does not add true capacity to organizations, people do.

    Jul 31, 2016
  • Cristine -

    Thanks for the shout out. We're focusing more and more on shared human capital ("service") in our model as that is in highest demand, in our view of the cultural sector at least. Most organizations are not scalable by virtue of their mission or cultural practice -- about 70% of arts and culture organizations nationwide operate with budgets less than $25k! This means that they are never going to achieve the scale to build independent, full-charge, supporting infrastructure. The only way to get high-quality, integrated support, in our view, is to share these resources as a "management commons". We're in the early stages of franchising our model to Houston, and potentially to Denver as an initial foray into national expansion.

    Jul 31, 2016
  • Agreed about this being a great response. A fellow colleague at a small non-profit recently had the exact situation you described. The contractor applied for unemployment benefits, an investigation was triggered and the non-profit had to pay tens of thousands of dollars in fines and back taxes. An attorney they consulted with suggested that another test is if the work is core to your operations then the individual should probably be classified as an employee vs. an independent contractor. When we consider just the test of set their own hours, most of us would probably have few independent contractors. After this happened, I quickly converted two individuals to employee status.

    Jul 28, 2016
  • Thank you Valarie! Sounds like you made the right call with the two workers at your organization.

    Jul 29, 2016
  • There are a few points, above, that are incorrect or that need clarification:

    1) If the contractor is a "sole-proprietor" then he/she may maintain one bank account for personal and business use. The accounting method utilized for tax purposes under this setup is called a "cash drawer" and is perfectly legal.

    2) If the contractor is a sole-proprietor, he/she does not need to maintain any insurance, unless state or federally required, based on the type of work that is performed.

    3) Clarification: some contractors specialize in managing long-term large projects (often for multiple years). Often, in these cases, the contractor will only have one client at a time. This is perfectly legal.

    And a couple of final notes:

    As an independent consultant who works with many public sector non-profits, it is my experience that small organizations in particular can greatly benefit from hiring consultants rather than staff. The benefit is that you can slice up your needs then hire contractors who have expertise in that specific area. What your organization accomplishes is then compounded. It is very rare to find all the expertise you need with only one worker.

    Depending on your needs and budget, you may be able to find consultants who will offer you a reduced rate if you can guarantee a monthly retainer or minimum yearly spend.

    Jul 28, 2016
  • Susan, thank you for the comments and suggestions. Your point about guaranteeing a minimum spend to get a discount is very helpful. It's always good to get the inside perspective.

    Jul 29, 2016
  • Very well articulated piece. And so important for nonprofit leaders to understand.

    Jul 28, 2016
  • Thank you Glenn!

    Jul 29, 2016
  • This article is frighteningly incomplete! It ignores the nationwide impact of FLSA rulings, set to go in effect on December 1, 2016. These rules redefine "independent contractor" and dramatically constrain ability of nonprofits (and all businesses) to hire workers as independent contractors. According to these new rules, virtually all workers are employees, and most will need to be reclassified as non-exempt employees. As well, the new wage rule *doubles* minimum salary requirements for employees, to $913 per week.

    Jul 28, 2016
  • Cheryl, thank you for commenting. This article is strictly intended to give a very general explanation of the risk of misclassifying an employee as an independent contractor. The new FLSA rules on exempt salary threshold are absolutely a critical issue for nonprofits across the country and I agree that many workers will have to be reclassified as nonexempt (hourly). This is a great idea for a future Blue Avocado article!

    Jul 29, 2016
  • I too have a small non profit that serves the homeless. I used very part time college workers to train our homeless clients and take them out to remove graffiti in our city on bikes. They received a "stipend" for 4 hours, one day per week. But I was notified that this was in a grey area and I could no longer provide them this service. We had insurance but no Workman's Comp. We have been helping people for a long time but now have learned any of our ideas need to be run past our attorney first for clarity. The "grey" is growing and too often becoming a serious issue. Be very careful!

    Jul 29, 2016
  • You are absolutely right, Deborah. In the long run, a cautious approach serves the nonprofit well.

    Jul 29, 2016
  • Lots of good information here. I want to point out the biggest reason I would rather hire employees. Passion for the mission- the point of any nonprofit. Independent contractors and consultants are not generally going to commit in a way that your employees (theoretically, if you hire wisely) will. Give me passion and loyalty any day.

    Aug 01, 2016
  • Hi Pam,
    I definitely hear your point. However, as a consultant myself, I am extremely passionate about my clients - I consider it an honor to work with such great organizations. Since I'm an event planner, it really makes sense for the org to hire an independent contractor to do a very set defined role (i.e. an event) rather than trying to have overworked staff working on something outside their job description. With the majority of my clients, I've been working with them year after year and it's a great model.

    Great article Siobhan!

    Aug 13, 2016
  • Very helpful article from an employment standpoint as well. I was classified as an independent contractor by a for profit business and when they let me go I had no way of collecting unemployment. Thankfully, I was not out of work long, but it was during the economic downturn and I was really scared. Anytime I have interviewed for employment since, I avoid that label like the plague. I won't be put in that position ever again. Something for those of you doing the hiring to also consider.

    Aug 19, 2016
  • Hey Siobhan,

    I'm in the workers' compensation industry, and we run into this issue a lot. Everybody wants to 1099 people the IRS actually considers "employees." If you don't want to hire an employee, an alternative might be to hire somebody from a temp company. This would be more expensive than using a 1099 contractor, but less expensive than incorrectly paying a 1099 subcontractor who is later identified as an employee, and then getting audited and owing back-taxes. Another idea might be to hire people called "freelancers" online if the work can be done remotely. Anyways, great article. Thanks for writing!

    Sincerely,
    Mike Smith
    Owner & Webmaster - https://classcodes.com/

    Dec 20, 2016

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