Plain-English answers to questions about hiring independent contractors -- and the differences between contractors and employees.

What's Below:

What is an independent contractor?
What are the benefits of hiring independent contractors?
What are the risks of hiring independent contractors?
How do government agencies determine whether workers are ICs or employees?
Should I ask freelancers and consultants to sign written independent contractor agreements?
How can I prove that the worker I hired is really an independent contractor?
Who owns intellectual property created by independent contractors?

What is an independent contractor?

Independent contractors (ICs) are people who contract to perform services for others, but aren't legally employees. Because many employment laws and tax rules that cover employees don't apply to ICs, businesses can often save time, money, and headaches by hiring ICs instead of employees.

ICs may call themselves by a variety of names -- freelancers, consultants, the self-employed, entrepreneurs, or business owners.

What are the benefits of hiring independent contractors?

Businesses can often save money by hiring ICs instead of employees. In addition to salaries or other compensation, employers have to pay additional expenses for employees, like payroll taxes, insurance premiums, and employee benefits. When hiring ICs, you don't have these expenses.

Hiring ICs instead of employees also reduces exposure to some types of lawsuits, such as those alleging job discrimination or wrongful termination.

Most importantly for many employers, ICs provide a level of flexibility that can't be obtained with employees. You can pay an IC to accomplish only a specific task, allowing your business to get specialized expertise for a short period -- without having to pay for training.

What are the risks of hiring independent contractors?

Despite the advantages, many businesses are wary of using ICs because they have heard about or experienced the consequences of misclassifying as ICs workers who are, according to the law, actually employees. And it's true that the consequences can be economically devastating. A business must pay the IRS all back taxes owed, with interest, plus a penalty of 12% to 35% of the tax bill.

Audits by state agencies are even more common than IRS audits. State audits most frequently occur when workers classified as ICs apply for unemployment compensation after their services are terminated.

Another major disadvantage of hiring ICs is that they can sue you for negligence if they are injured on the job. This is something employees normally cannot do, because their work injuries are covered by workers' compensation insurance.

How do government agencies determine whether workers are ICs or employees?

There is no single, clear-cut test for deciding whether a worker classified as an IC is actually an employee. Different legal tests are used by various government agencies, including:

• the Internal Revenue Service
• state unemployment compensation insurance agencies
• state workers' compensation insurance agencies
• state tax departments
• the United States Labor Department, and
• the National Labor Relations Board.

Each of these agencies is concerned with worker classification for different reasons, and has different biases and practices. Each agency normally makes classification decisions on its own and need not consider what other agencies have done, which means that one agency can find that a worker is an IC while another decides that he or she is an employee. It's also possible, though rare, for a worker to be deemed an IC in one state and an employee in another.

To find out the rules these agencies use, see Independent Contractor or Employee: How Government Agencies Make the Call.