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What You Need to Know When Your Business Needs Workers

What You Need to Know When Your Business Needs WorkersUsing other people to operate your money machine.

When your business needs other people's time and efforts, you will be subject to a whole range of rules, laws and forms to file. Compliance with these rules, laws and proper filing of forms will save you much trouble in the future. 

This summary gives a basic overview of the laws, rules and forms for employer/employee, and use independent contractors for needed labor.
The rules are complex legal concepts. We summarize them in easy to understand language. If you are thinking of your own twist to the basic rules, seek competent assistance to get set up right before you "hire" anyone.

The Need for Personnel Most businesses eventually reach a point where the business needs labor to complete required tasks. If the business is to grow and thrive it needs labor to accomplish various tasks.

How Needed Personnel Can Be Obtained If your company has reached this point and/or has been there for a while, you probably have discovered there are only limited labor sources:

  1. Bring in a partner to provide needed labor.
  2. Merge your company with another that is already set up to provide the labor.
  3. Contract with another company to provide the labor.
  4. Hire employees.

The first two of these options are beyond the scope of this summary. That leaves contracting for the labor from another company (an outside or independent contractor) or having employees. This summary will assist you to make the appropriate choice by outlining the responsibilities and rules for each choice.

Understanding the Terms

Business Entity

A business entity is: an organization which brings together knowledge, skills and tools to produce a product or service to be marketed to other individuals or entities with the expectation of producing a profit. The business entity will have: its own name or identity, a business location or office, a means of contact, prices or fee schedule for its products or services, tools and/or skills which enable it to make its product or provide its service its customers, a business license or government business identification number(s), a set of books of account, owner(s) who stand to earn a profit or may sustain a loss, etc.
The entity owner(s) are not the business! The entity is its own “person.” This is one of the hardest ideas for most business owners to accept, and yet is basic to the understanding of the legal positions with which the owner must come to grips. It is somewhat easier to separate yourself from the business when there is a partnership or corporation involved. Even then some owners never make the distinction.


Any time an individual's labor is used to accomplish work for pay there is an employee/employer relationship. The employer is the entity that actually pays the individual to perform the labor. The Employer is responsible for the collection and pay-over of payroll taxes, unemployment insurance, and worker’s compensation insurance. A common business tactic to avoid payroll tax responsibilities has been to use "independent contractors". Unfortunately, in many cases, this is not a legal remedy.


Federal and therefore State law holds that "a worker will be classified as an employee if they fall into any one of the following categories;

  1. A "common law employee", an individual who performs services subject to the control (exercised or not) and will of the employer.
  2. A corporate officer
  3. Statutory employees (employees in certain fields who are classified as employees by law specifically).

State laws go further in stating that the definition of employment is broad and inclusive and is not limited by the meaning of the master-servant relationship.
The employment laws clearly indicate that when labor is done by an individual the employee-employer relationship exists. The only open question is, who’s employee is the person? The employee may be an employee of your business or someone else's business. In either case the responsibility of the employee will fall under the various tax and employment insurance laws.

Independent Contractor

Independent contractors must meet three factual requirements:

  1. The contractor true business entity. If the independent contractor is not a true business entity then they are not in a position to contract for labor services. Contracts can only be made between business entities. The business entity may be a sole proprietorship with only one worker, but never the individual. Your company needs to contract with another real business entity for the use of that company’s employees. You can never contract with an individual for their labor and have an independent contractor relationship.
  2. The independent contractor’s employees may not contract for the labor needed to do those tasks for which your business was established and upon which it depends for its very survival and at your location using your tools and equipment.
  3. The regulators view this second requirement as an issue because when the success or continuation of a business depends to an appreciable degree upon the performance of certain kinds of services, the people who perform those services must necessarily be subject to a certain amount of control by the owner of the business. Control always means employee.

The independent contractor must have the risk of losing money when fulfilling the terms of the contracting agreement.

Employer Responsibilities and Costs

Subject to employment tax laws

All business entities that use individuals for labor are subject to the same employment tax laws and employment insurance laws. The specific laws vary in their effect on the employing entity. Payroll taxes are primarily a cost to the employee, with the exception of the matching of withholdings for FICA and Medicare. Employment insurance (Unemployment Insurance and Worker’s Compensation Insurance) are totally a cost to the employer, and may NOT be assessed to the employee.

Employment tax laws:

Employers are required by law to withhold from wages paid amounts for federal income tax, one half of the FICA and Medicare insurance assessments, and where applicable state income tax. The employer is responsible for the other one half of the FICA and Medicare insurances assessments. All of these taxes are paid over to the respective governments on a regular basis.

The real cost of employees (download the worksheet - PDF)

The subject, “employees vs independent contractors,” always comes down to controlling cost. There is, of course, the matter of "all the extra paperwork" involved with having employees, but this is really a perceptional difference.
First, cost. As a rule of thumb, employees will cost you about 11% more than their base rate. This figure does not include worker compensation insurance, which varies by industry, nor does it include other "fringe" benefits. All fringe benefits can be paid for by the employee. Matching FICA and Medicare, worker compensation insurance and unemployment insurance are not considered fringe benefits. If you were to compare wage rates plus costs to the rate of independents you would likely find that the employee may cost less.

Second, the extra paperwork. Once you are familiar with the required filings and payment periods, the extra work will amount to about 1 hour per month for each five employees. You can eliminate most of that time by hiring a payroll service. These services are very reasonable. This is comparable to the time needed to properly keep the documents and contracts for independent contractors.

The real advantages to employees over independents is control, you get to say what, when, how, and why. They will be where you need them when you need them.

Problems When Using Independent Contractors 

Dangers of making the wrong decision

Before you can make a proper decision in this matter, you need to understand the legal position of you and your company in relation to the worker. A wrong action on your part could cost you as much as your entire business, or more. Trying to avoid certain responsibilities can be more costly than "doing it right".
When penalties are levied by the IRS, they can total twice the tax that would have been due had the worker been classified an employee right from the start. On top of that, employers then may be required to extend regular employee benefits to the reclassified workers. That can amount to between 30% and 40% of the basic pay.

How to minimize the risk of re-classification

When contracting with independent contractors there are a number of things you never want to do:

  1. Never require the independent to work exclusively for your business (except for a specified SHORT period of time).
  2. Never establish quality standards for the work to be completed (except you may inspect task(s) as completed to see if they meet your satisfaction or specifications).
  3. Try to use a contract or fixed rate, if you contract for an hourly rate be sure that the contractor always invoices you for the time expended.
  4. You may not terminate the work during the term of the contract except where contractor violates the terms of the contract or fails to produce up to specifications.
  5. Never provide training to the contractor regarding the task(s) to be performed.
  6. Never provide tools or any other benefits to the contractor.
  7. You may not dictate the time for performance; though the contract may specify a time period in which the task(s) are to be completed.
  8. NEVER! NEVER! NEVER pay an individual, you must contract with and pay a business entity.
  9. Never combine the business of the contractor with your business in any way.

Additional areas of concern

In addition to the above there are some other areas that should be dealt with very carefully. A most prominent one is the reimbursement of expenses incurred by the independent. This issue should be dealt with in the engagement contract and should be closely documented. These reimbursement checks should never be written to an individual.

The need for a written agreement

Although a written agreement of contract is not absolutely required, it is best to always have such an agreement especially in instances where the task(s) to be completed may resemble those normally done by your business. The agreement should be made between your business and their business, not between you and the other owner. It should include all of the basic requirements of an enforceable contract. It should include statements addressing responsibility for the payroll and other taxes. It should state that the owner and/or any of its "employees" are not entitled to any benefits from your company.


Related Articles: Can You Use Independent Contractors?