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May 1, 2012

Companies may find they need people with certain skills, but are concerned about expanding their workforce with regular employees and the overhead concomitant with employees (unemployment insurance taxes, worker’s compensation insurance, payroll costs, etc.) One solution is to supplement the workforce with independent contractors.

Governmental agencies like the Illinois Department of Employment Security (IDES), the Illinois Department of Labor, and the IRS increasingly are challenging companies’ classifications of workers as independent contractors. These agencies start with the presumption that the company is the legal employer of the independent contractor. Therefore, when a company pays the worker to perform services, the worker is presumed to be the employee of the company upon audit by the agency. Consequently, every company using independent contractors should seriously be preparing, long before an audit or any other legal challenge, to prove that the independent contractor is not a company employee.

How does a company do this? The crux is to prove that the independent contractor is self-employed. What are some indications that an individual is self-employed? One indicator of self-employment is an independent contractor who is incorporated and in “good standing” with the state of incorporation. If the independent contractor is not incorporated, and not willing to be incorporated, make sure that the contractor has a business name as a sole proprietor and uses that business name. Effective proof includes documents showing that the worker holds himself out under his own business name, checks from the company made out to the independent contractor’s business name with the contractor endorsing the checks with his business name, IRS Forms 1099 made out to the business name of the independent contractor, a well-drafted independent contractor agreement, and proof that if the company closed its door tomorrow, the independent contractor could continue to function as a self-employed entity. If the contractor needs a license in order to perform the work, require proof of the license and a copy. A contractor will have a hard time establishing an independent contractor relationship with a roofing subcontractor if the latter does not have the roofing license required by the Illinois Roofing Industry Licensing Act. Companies should maintain files for each independent contractor and include these materials in each file.

The IRS and the IDES have their own detailed checklist of rules and regulations to prove that the workers are independent contractors. The Illinois Employee Classification Act, which applies to construction-related companies, has a test which is particularly difficult for companies to meet.

Penalties for worker misclassification are steep. Careful assessment of worker relationships and taking practical steps can significantly lower your company’s exposure.