When Outsourcing Makes You Go "Ouch!"

When does “outsourcing” make you go “ouch!”? When you receive a notice from the Department of Labor, assessing you penalties and interest for not paying payroll taxes for your “employee.”

“But no!” you cry. “This was an independent contractor! We had an agreement.” “Too bad,” says the Department of Labor. “It’s not what you call the relationship – it’s how we view it.”

That’s a tough lesson for entrepreneurs. You’re up to your eyeballs in paperwork. You’ve only found 24 hours in each day. You need help.

So you hire your next-door-neighbor’s kid, a recent college graduate, (thrilled to be earning some money, given dim job prospects) to help with bookkeeping. You make it clear that she needs to pay her own payroll taxes. She agrees, and is happy with the arrangement. The kid is free to take on other jobs, other assignments for other people. So why isn’t she an independent contractor?

It comes down to how “controlling” you are.

The main difference between an employee and an independent contractor is the degree of control you have over the worker. The more control you exert, the more likely your contractor will be seen as an employee. The government looks at three main categories: (1) behavioral control; (2) financial control; and (3) the relationship of the parties.

Behavioral Control

A business has “behavioral control” when it can direct or control how the work gets done. For example:

  • Do you give extensive instructions and training to the worker?
  • Do you decide what the worker will do and when?
  • Do you provide the equipment, supplies, or materials?

The more of these to which you answer "yes," the more likely it is that you are hiring an employee. In the situation with the neighbor’s kid, who came to your home to do your bookkeeping, you were likely doing all three.

Financial Control

To what extent are you controlling the “business aspects” of the work being done?

  • Has the worker made her own financial investment in her business?
  • Does she have to pay for her own business expenses, such as rent and utilities, licensing or professional dues, or advertising expenses?
  • Does the worker take a risk on the transaction by either realizing a profit or incurring a loss?

If the answer is "no" to these criteria, the scales again tip to the employee side. Once again, the neighbor’s kid, who doesn’t have other “clients,” hasn’t taken any financial risk, and doesn’t pay business expenses, shows a lack of independent financial control.   

Your Business Relationship

If it walks like a duck and swims like a duck . . . does it also quack like a duck? What’s your relationship with this worker? Does it sound like an employee-type relationship?

  • Do you provide benefits such as insurance, pension, or paid vacation?
  • Do you have a written agreement suggesting that the worker is an employee?
  • Do you make payments for the worker’s services to an individual instead of a corporation?

With your neighbor’s kid, although you’re not paying benefits of any kind, you are paying the “fees” to an individual, not a business entity. And that, plus the evaluation of the behavioral and financial control factors, makes it likely she’ll be considered an employee, not a contractor.

Get Your Ducks in a Row

Let’s face it: the government wants the tax revenue that comes from treating workers as employees. And the penalties and fines for non-compliance can be stiff (not to mention, it gives the agency the right to nose around in your books for other violations). So when you’re thinking about outsourcing, get your ducks in a row and choose your contractors carefully.

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