Follow the Rules When Using Independent Contractors

One of the most significant costs for many nonprofits is people. Volunteers can only do so much, and to grow your organization and maintain consistent services, people need to be paid. Whether it’s an administrative position, a program manager, a driver or an instructor, that person trades commitment of time and skill for compensation.

Hiring someone as an employee adds costs and obligations – some defined by you and others by law. Employees must be covered by workers’ compensation insurance and unemployment insurance. Social Security and Medicare tax withholdings are matched by the employer, and all taxes must be reported and deposited in a timely manner. If your nonprofit offers benefits such as health insurance, disability or paid time off, these costs also need to be taken into account.

In the face of regulations and costs that can boost salary expense by 40 percent or more, some managers are opting to hire individuals as contractors. On the surface, it’s simple: Hire people, pay them by the hour, week or month, and they take care of their own taxes and benefits.

First, when paying someone as an independent contractor, recognize that taxes and benefit costs have shifted to that person and should be reflected in a higher rate.

Second, don’t refer to them as employees, and don’t call their wages a salary.

The Internal Revenue Service takes the payment of employee taxes very seriously. This is an area where, if you fall on the wrong side of the law, your organization will be liable for back taxes and penalties, often much greater than what was originally owed.

The answer lies in the title: independent contractor.

Essentially, independent contractors work for themselves and provide you with services. They file their earnings as self-employment or under a business entity. This has to be clearly understood by the person you hire. Many an organization has thought all was fine until someone gets hurt on the job and files a workers’ compensation claim. Or you lay them off and they file for unemployment. Fortunately, there are definitions of how to correctly categorize workers. The IRS uses the following tests:

Behavioral – How much of the person’s work do you control? Do you assign tasks, supervise and evaluate? With both employees and contractors the answer might be “yes.” The defining line is how much and how detailed instruction and evaluation are. An accountant who comes in periodically to do the books could fall more on the independent scale while an assistant constantly being given new tasks and supervised closely would not.

Working under contract requires a scope of services – if you’re changing a contractor’s workload without discussion, then you’re treating the person like an employee.

Training is another area where the more intensive and detailed – the more likely the person is an employee. If you want someone to do tasks in a particular way in a certain order, that person could be categorized as an employee. If you insist the worker attend all staff meetings and participate in other employee activities, then that will weigh toward the employee classification.

Financial – Does the person supply their own tools and equipment for the job? Does the person work out of a home office? Again, according to the position, both employees and contractors might do this. A key test is whether they are free to seek and take on similar work with other organizations.

As stated above, a truly independent contractor is in business with the intent to make a profit. You cannot require exclusive services from someone and then call that person a contractor.

Again, expect to pay more. A contractor has exchanged the tax and other benefits related to employment to be self-employed. Their income needs to cover that.

Type of relationship – Although having a written contract is important, it’s not sufficient to prove someone is not an employee. Neither is lack of benefits. Two areas the IRS looks at closely are permanency of the relationship and whether the function is key to your operation; for example, if the person provides direct services to your client for a core activity.

Long-term contract arrangements are fine, but you should at the least sign agreements with an end date. (Renewal is possible of course.) Employment is considered more open-ended, with termination for cause or downsizing by the employer or notice given by the employee.

Bringing on contractors can benefit your organization – if they pass these tests. This can be a way to add expertise that you could not afford on a full-time basis or for projects that are time-limited. One small nonprofit might contract with a CPA to perform certain top-level accounting functions. Another might contract grant writers or strategic planners.

As with all business relationships, the employee or contractor arrangement must benefit both parties. Treating people as employees while denying their matching taxes, insurances or other benefits by calling them contractors will not pass the test.

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