Is Your Consultant Really an Employee?

Do you wonder if your hire is really an employee?

So you want to hire an employee.  Sometimes Consultants are often hired to supplement an organization’s staff while saving the costs of hiring a full-time employee. Consultants are  experts in their field and are paid to share their knowledge and expertise to help solve problems and reach goals.  While companies have many legitimate reasons for hiring consultants instead of employees, you should understand the differences to avoid potential tax liability.

In the United States, if the IRS determines that a consultant’s relationship to a client qualifies as an employer-employee relationship, the client is responsible for the employer’s portion of Social Security and Medicare taxes for the period the consultant was engaged (currently 7.65% of qualifying wages), but also penalties and interest.  It is also essential the client contributes to unemployment compensation and holds workers’ compensation insurance.  If the IRS cannot clearly identify whether the consultant paid income taxes on the money paid to the consultant, the client could also be held responsible for paying those taxes. So in the worst case, it’s possible that a client might have to pay nearly half of what they already paid the consultant to Uncle Sam.

In most industries, provisions exist to prevent this kind of catastrophe. So-called “safe harbor” rules seek to ensure that as long as your client engaged you as an independent contractor, in good faith (and not just to avoid employee status), then they cannot be held liable.

The IRS can punish offenders without warning, whether or not they were previously aware of their non-compliance. Many companies would rather stick with employees to eliminate that risk.

The IRS lists and describes twenty factors to be considered in differentiating between employees and independent contractors. Employers can use these factors, which were developed from past court cases and rulings, in evaluating their own workforces to determine that workers are appropriately classified.

It is important to understand that the weight to be given to each factor will vary depending on each individual situation. Often the occupation of the particular worker being classified will be of vital importance in determining which factors are most relevant. If you need assistance with classifications, contact us.

Based on the factors in the IRS Revenue Ruling 87-41, companies should assess their current practices in regard to their treatment of consultants and subcontractors for withholding and payroll tax purposes. Keep in mind that improper classification of employees as independent contractors could expose a company to substantial liability for the payment of back taxes if the IRS were to successfully challenge the treatment.

What can independent consultants do about this? Here is my understanding of an independent contractor.  We hope this will provide you with some necessary guidance.

  1. Instructions. Employers dictate how, where, and when work must be accomplished, while clients express a need that an independent consultant fills in their own way. Consultants know that, in practice, there are a lot of shades of grey here. Clients always have constraints on how they want the job done, and some employers give their employees just as much freedom in choosing implementation.
  2. Training. If the client provides training for you, that demonstrates an employer relationship; to protect against this, you should always acquire your own training. If you really can’t afford to obtain the training that your client wants you to have, then you need to creatively structure your billing to cover the costs without making them pay for it directly.
  3. Integration. This is another tricky one. To the degree that the success of your client’s business depends on your efforts, the same degree of employer control may be presumed. If your client can’t live without you, then you’re considered part of their organization. I know that a number of my clients would be vulnerable on that point.
  4. Services rendered personally. If one specific individual must perform the work, then the individual may be considered an employee. That really hits independents hard, because we’re usually flying solo. I’ve had clients who insisted that our contract explicitly require me to perform all work personally.
  5. Responsibility for Assistants. If you need assistance in performing your duties for the client, you should hire those Assistants yourself. If the Assistants are provided by the client, then you might be considered an employee. This is another area that usually trips us up, because it’s generally impossible for us to do our work without significant interaction with the client’s employees.
  6. Continuing relationship. If the engagement does not have a discrete term, or even if the client keeps coming back to you time and again, that could be construed as an employee relationship. Consultants know that long-term clients are our bread and butter. I have several clients with whom I have had engagements of one form or another for several years now.
  7. Hours of work. If the client establishes the hours during which you must perform the work, then they are your boss. This requirement is usually easy for independents to meet, because we like to set our own hours; however, I have had clients who insisted that I be available on a regular schedule and that pushes this point beyond the employer-employee relationship.
  8. Full time. If you’re required to work for a single client full time, that’s waving the red cape in front of the IRS’s horns. You should never commit to full time for one client. Not only is it potentially a liability for them, but it’s putting all your eggs in their company’s basket.
  9. Work on premises. If you’re required to perform the work at the client’s site, then you could be considered an employee. Many professional consultants generally don’t have a problem working remotely, but for those who must interact with the client on a day-to-day basis, this could be a problem. Just make sure the client doesn’t allocate a cubicle or office for you.
  10. Order or sequence. When the client dictates the order of the steps you must take in order to produce a result, that’s considered employer control.

    What does that say about project milestones? How closely does the person need to be under their control?

  11. Oral or written reports. The requirement of regular progress reports also indicates control by the employer. Consultants know that regular communication with clients is absolutely essential to success. So you need to make those reports look like your firm is seeking feedback or that these reports are simply part of your deliverable services, rather than being required to “check in” by your client.
  12. Payment by the hour, week, or month. Apparently, the IRS considers anything other than fixed price billing an indication of an employer-employee relationship. One way in which that can be made to appear more independent is to enumerate the accomplishments of each of those hours in your invoice, like lawyers do.
  13. Expenses. If you cover your own expenses for your business and travel, you’re not an employee. I usually add these expenses into my agreements to prevent this issue from happening.
  14. Tools and materials. You should purchase your own equipment, software licenses, membership affiliations, and office supplies. If your client pays for those, you could be considered their employee.
  15. Significant investment. Employees generally aren’t required to make any investment in the services they provide, while independents who are running their own business must put up some money. Besides office space, equipment, supplies, and advertising, you also have your business licenses, taxes, subscriptions, and membership dues.
  16. Profit or loss. If you’re truly independent, then any given engagement could result in a loss due to poor planning or unforeseen circumstances. Employees have no such risk. I try to mitigate my risk of loss by outlining all the terms of billing on a price schedule, given to my clients as part of an agreement.
  17. More than one client. Similar to the full-time factor, having only one client indicates an employee relationship.  This is an area many businesses have trouble proving.  It makes perfect sense to have multiple clients, in addition to being tax savvy.
  18. Publicly available. If you’re marketing your services to the general public, that argues for independence. In your quest to obtain new clients, document your expenditures for advertising and promotion in your agreement.
  19. Right to discharge. Your agreement should state that either party may terminate for cause; this means that your client can’t just let you go on a whim — they must honor the contract unless you breach it. That makes you equal business partners, instead of employer/employee.
  20. Right to terminate. The converse is also true. You should be bound by the terms of your contract, not working as an “employee at will.”  I try to take some type of retainer to prevent this from happening.

Consultants bring a fresh approach, an outside eye to your business.  They provide the extra horse-power and the specialized skills to help your business succeed.  Dube Consulting would like to partner with your business. 

17 thoughts on “Is Your Consultant Really an Employee?”

    • Kelly,
      I am not an attorney, but classifying employees with an employer – employee relationship is critical. As a 1099, do you work independently, self-directed and have your own business with other clients?

  1. What is the law regarding independent contractors having their own workers’ compensation insurance (in CA)? Is this a requirement? I’m trying to find any writing or where I can get that information. Do you have any references? Thank you!

  2. Hi,
    Do these same rules apply if we were to hire someone internationally? Does it default to the international country guidelines?

  3. What if a company based in the States hires an overseas consultant in Mexico and the consultant operates under a company name registered in South Africa? Ethically, where should he file his taxes?

  4. I’m glad that your article mentions how an independent consultant can combat potential issues by working full time for a client. My mother’s looking to hire a tax consultant. I’ll be sure to send your article to them to help them out!

  5. Our company would like to obtain a consulant as a COO. He doesn’t want to be considered an employee because it would be a conflict of interest to their other clients. How would we categorize him on our payroll, since we do want him to be our COO?


Leave a Comment