Employee vs. Independent Contractor
The issue is whether or not an individual is working for you as an employee (where you are in control of just about everything) or you have contracted them as an independent contractor (where they own their own business). The consequences of this issue are too frequently overlooked. Many businesses will try to classify their workers as independent contractors in an effort to reduce payroll taxes and avoid items like workmens compensation insurance.
Determining Status
There has been many publications/articles written on how to determine an individuals status as either independent contractor or employee. Every situation is unique and determined by facts and circumstances. Some of the facts used to determine the status would be items like: (1) do they advertise their services, (2) do they do work for others, (3) do they have their own tools, (4) do they control who provides services, (5) do they have their own licenses, (6) do they have business bank accounts, (7) is there a continuing relationship, (8) are they paid hourly, etc. NOTE: The fact that you have a contract that states the person is to be an independent contractor may have little effect on the determination (i.e. Wal-Mart can not establish an independent contractor relationship with their cashiers simply by having them sign a contract).
Basically you can ask yourself one question, "Do they truly have their own established business?" If so, then treating them as an independent contractor is appropriate. The consequences of getting this wrong are: (1) you could be responsible for paying all the payroll taxes (including the employees share), and (2) you could be held liable for all damages relating to work injuries.
Potential Payroll Tax Liability
Say you pay an Individual $20,000 for the year. If you had paid them as an employee you might have paid them $16,000 ($20,000 less $4,000 of withholdings) and then paid out a corresponding $6,000 in payroll taxes and insurance. So your total cost might have been $22,000 which is $2,000 more than if you had paid them as independent contractor. This is one of the reasons why employers are tempted to treat individuals as independent contractors.
Now, if you issue this person a 1099 for $20,000 for the year and their accountant determines that they were actually an employee, you could owe quite a bit more. Your "Independent Contractor" may owe several thousand dollars on their tax return if reported as an independent contractor, but could get back several thousand dollars if reported as an employee. If this person is no longer providing services for you, which do you think they will choose?
Lets take a look at the numbers. Their accountant will now say that the $20,000 was the net paycheck and will "gross it up" showing something like $25,000 as the gross with $5,000 of withholdings (there are federal tax cases supporting this position). They can do this by filling out two short forms to report the miss-classification and the "correct" employee W-2 figures to the IRS. Now you are going to be out the $20,000 paid to the employee, $8,000 in payroll taxes and insurance, and $2,000 in penalties. So now instead of paying out $22,000 (if you had treated them as an employee from the beginning), you are going to be paying out $30,000. What makes this worse is the possibility that the IRS will examine all the other "independent contractors" and reclassify others (potentially going back many years).
Potential Liability for Work Injuries
If your "independent contractor" gets hurt while working and it is later determined that the person is really an employee, you could be held liable for all the damages to that person and you will not be covered by insurance. This one could be a "game-over" scenario for your business and it would only take one person being miss-classified.
Chances of Discovery
The chances of a miss-classification being discovered is pretty high when compared to other compliance issues. Ex-employees will be encouraged by their tax prepares to report miss-classifications to the IRS. I have heard that some preparers have stacks of the necessary forms already on their desk. Also, I have seen national ads for companies that want to "help" those who have been miss-classified as independent contractors. Workers Compensation audits, where an auditor will come out to your business and dig through your records looking for employees that have been miss-classified as independent contractors, are fairly common. If an employee gets injured, at some point a social worker will be asking them a series of questions to help determine how their medical bills are going to be paid. There are plenty of other methods of discovery (i.e. child support, court actions, government audit of your "independent contractors" tax return, etc.).
Conclusion
I would recommend getting the worker classification correct. Even if the worker only does $50 of work, you may not have much exposure to payroll tax liability, but you still have exposure to work injury (even something as simple as cleaning some cars could result in Injury and the fact you only paid them $50 will not matter). Personally I think this is a little bit of a stretch, but I've heard of companies in California paying people about $20 as an employee for their job interview in case they get injured while at their office. The bottom line is that you are taking large risks when you have employees miss-classified as independent contractors.
