What is an independent contractor?

Independent contractors (ICs) are people who contract to perform services for others, but don't have the legal status of employees. Because many employment laws and tax rules that cover employees don't apply to ICs, businesses can 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 usually save money by hiring ICs instead of employees. In addition to salaries or other compensation, employers generally have to pay additional expenses for employees, including payroll taxes, insurance premiums, employee benefits, and more.

When you hire ICs instead of employees, you also have reduced exposure to some types of lawsuits, such as those alleging job discrimination or wrongful termination.

Most importantly for many firms, 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, legally, 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.