Many companies use independent contractors to slash payroll taxes and the high cost of benefits. But contractor tax issues are a big concern, and you have to be careful.

The IRS is on the lookout for companies that use these consultants improperly – especially those that lay off workers and then hire them back as independent contractors, simply to cut labor costs.

Tactics like that don’t go over well at the tax agency, so it published guidelines on how auditors should analyze consultants and independent contractors.


Often, an audit of the worker means a look at the company as well. Audits by state agencies are common, especially when freelancers apply for unemployment compensation.

If your independent contractors are legitimately independent, there’s no problem. But if they’re employees in disguise, the IRS can “reclassify” them as employees and slap you with hefty bills for back taxes, plus interest and penalties.

Your company’s pension plan isn’t immune either. As independent contractors, workers are generally excluded from retirement plan contributions. If the IRS reclassifies them, your company may be penalized and your qualified plan might be disqualified.

Avoiding Tax Issues

To avoid contractor tax issues, consult your tax adviser and make sure freelancers sign contracts that specify that:

They are not employees for federal income tax purposes and are responsible for paying their own Social Security and Medicare taxes.

They are not entitled to employee benefits and are not covered by workers’ compensation.

Meanwhile, have your regular employees sign contracts, too. By varying the two documents, you can show the IRS that the contractors and employees perform different tasks.

Four More Tips to Help Safeguard Your Company

  1. Consistently treat all workers performing similar tasks as either independent contractors or employees. If contractors must wear ID badges or use company vehicles, make sure their contracts explain why. For example, “the policy was instituted after customers expressed safety concerns about deliveries in unmarked cars.”
  2. Give outside workers considerable discretion about how and when they perform their duties. In general, independent contractors must control the way they get the job done.
  3. Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year.
  4. Don’t supply freelancers with services you give employees. Some companies have run into trouble with the IRS for providing contractors with office space, computers, cars and other perks. Independents generally furnish their own tools and materials.

So what if you do rehire some laid-off employees as independent contractors? There’s nothing illegal about rehiring former workers as freelancers. You just have to make sure you structure the deals properly.

To avoid contractor tax issues, classify them as contractors, give them new titles and don’t let them work in your office. For example, “service agents” versus “outside service agents.”