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Independent contractors: When and why does a company need to convert a contractor to a FTE?
Is there a hard and fast rule? I read this post http://www.webbizfinance.com/2010/10/payroll-taxes-small-business/ that says the line can be a little blurry. Is there something that would show up as a red flag to the IRS that would help draw the line?
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9 Answers
The blog you linked to is incorrect as regards the lack of a bright line. The situation is analogous to falling out of a tree: when you hit the ground, either your leg is broken or it's not. When the proper evaluation is done, the situation is almost always very clear.
A few years ago, the IRS replaced its former 20 Question Test (which was pretty good) with a briefer three category evaluation. The core elements include: behavioral control, financial control, and the nature of the relationship.
Behavioral control essentially describes whether the business has a right to direct and control how the worker does the task for which he or she is engaged. It includes direction on when, where and how to work; supervision and training; and controls over whether other staff can be hired and where materials can be sourced.
Financial control address whether the business has a right to control the business aspects of the worker's job. While there are several elements, there are three simple tests that can reveal the worker's status:
1. Can the person work for others, including soliciting or performing work during the engagement?
2. Does the person have a risk of financial gain or loss (i.e., if a contractor can he make a profit or sustain a loss)?
3. Is the person paid by the project or on a per-hour basis? Some professional contractors (attorneys, for example) may be paid using incremental time; however, payments in increments is generally seen as the domain of employees.
The relationship type addresses intended duration, nature of the engagement, and whether the tasks are those typically performed by an employee. If the work is ongoing and the intent is to retain the worker indefinitely to perform it, the IRS sees this as intent of an employer-employee relationship. If the work, such as a cashier in a retail store, is generally performed by an employee, an independent contractor-cashier is not likely to pass muster.
If the intent is to create a contractor relationship in lieu of a probationary period for employment, the tasks performed are typically those of an employee, and the individual is provided training in how the task(s) are to be performed, and supervised regularly, the IRS will see that as an employee relationship. Over two decades, I've watched firms make this mistake repeatedly, often out of a desire to avoid offering benefits or paying taxes. It's a dangerous slope down which many well-meaning business owners and consultants have slipped.
The situation you describe is in violation of labor law. If the person is doing the same work, at the company's place of business, under the company's direction, with company specified hours and pay both before and after this "trial period", they were technically an employee the whole time. Independent contractor does not mean "temporary employee". It means a person who is in business for themselves. If you receive 1099 payment, you are by definition a business owner. A person whose place of work, mode of work, pay and hours are under the direction of an employer is an employee even if they only work for one hour.
I know this is widely disregarded in practice, but that doesn't make it legal.
An IRS discussion of this can be found here:
http://www.irs.gov/businesses/small/article/0,,id=99921,00.html
You can't "convert" an independent contractor to an employee. The person either is truly an independent contractor, who owns their own business, has other clients, has complete control over the work, and invoices the client; or they are legally an employee, with pay rate set by their employer, and the employer having control over when, where and how the work is done.
It's not that blurry, really. I don't see how a person can start and run their own business and not be aware that they are self-employed. If a person is not in business for themselves, and has been hired as an employee, that's also pretty straight-forward.
Two Great articles on this topic can also be found here
Independent Contractor (Self-Employed) or Employee? Still Confused? http://bit.ly/br0iJv
7 Costly Legal Myths in Contractor Workforce Management http://bit.ly/hDIqbM
Why would anyone go the contract route when they are really an employee? http://bit.ly/ej7JAr
As Mariette mentioned, a contractor is a business owner, an individual whom is their own boss, who may or may not have any employees. They cannot be "hired" or "fired"; they are not receiving any direction in how to manage their business, or the work done.
The best way to define a contractor is think of your lawyer, your doctor, or even your neighbouring supermarket -- they all provide work or service, or product for you, or your business.. and you pay them for their service, work or product. You can describe the work you need done, but you can't tell them how to do it - there can be no specifics in the way the work is done.. You pay for the results, and you pay for the work to be done within a specific time frame! and that is the limit of the contract..
What many of us mistakenly do is call Temp employees contractors.. That said, a temp employee - the company will make sure they do withholdings.
For those who are not convinced about why this topic is important see this -- Former Owners of MA Temporary Employment Agency Charged in Massive Payroll Scheme http://bit.ly/n8lLca
-- these guys are each facing 23 Years in prison, and over 750k in fines. (each)
And the Scary part, that hadn't YET included the DOL's provisions and penalties.. That will come for sure - and will be as hefty!
The Big 4's are often just as guilty in doing this behavior. I guess they may believe that it is worth their ROI to pay the penalty? They do put aside hundreds of Millions just for lawsuits..
It is amazing the Number of Large fortune 50 companies that have been busted in this area over the past year alone
. But, the issue is that Obama is cracking down on this area, and now Jail time, not just financial penalties are being pursued today
Also note Term Limits are a fallacy - Term Limits for Contingent Workers: Urban Legend or Necessary Fix? http://bit.ly/lhZmjf -- they actually can be more of a red flag during an audit
One interesting thing to come from all of this is that the Big 4 Firms that I worked for made sure no consultant, esp lead consultants, remained on an engagement more than 11 months, at which time they would rotate in another consultant. It was in this way that they ensured that they did not even skirt the issue of employee vs contractor.
Rule of thumb: The IRS/DOL/State agencies will most probably investigate any consultant/consulting firm that is working for the same Client for 12 consecutive months or more, esp when they are on-site 80-90% of their time.
Very good comments from everyone, I would like to add 2 items;
1. The main obvious driver behind increased scrutiny of misclassified employees is revenue. Both State governments and the IRS are after all sources available to collect money to stay in business. Since payroll taxes are the major contributor, you will find in some cases different agencies are working together to identify improper filings.
2. Liability associated with misclassification of employees (i.e. failure to pay payroll taxes) goes directly to the company owner. Even if the company is formally closed and liquidated - the former owners are still on the hook for unpaid payroll taxes plus penalties and interest.
Beware, the IRS is not your lender.
Hi Lori,
we frequently bring people on with a contract for a specified period of time and the contract states when the time period ends, we will either terminate the contract or offer them full time employment. They also have the option to terminate the contract on thier end. When they're brought on with a contract, they're not eligible to receive employment benefits and for that time period, they'll receive a 1099 vs. a W2 form.
I would say that provided that all of the paperwork is in line with the pay and tax structure, there would not be an issue.
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