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Paying an Independent Contractor? Are You Sure?

Paying an Independent Contractor? Are You Sure?

This is a conversation our staff members have with clients at least 4 or 5 times per week: The issue of a nonprofit hiring and paying an independent contractor. What is fascinating is the degree of resistance we often get when attempting to explain the way the IRS and the State see such matters. Seems like everybody has a story about how somebody else is doing things, so why can’t they do it, too?  It’s so much easier to just pay people as contractors.  Or is it?


Some employers believe they can treat any worker as an independent contractor instead of an employee, especially if both parties agree to the treatment.  That couldn’t be further from the truth.  Others do so knowing they shouldn’t, but they simply hope they don’t get caught.  Bad idea!

The reason businesses (including nonprofits) like to use independent contractors is simple:  it saves on employment taxes.  The problem lies in the fact that the person your nonprofit is paying is not an independent contractor simply because you want her to be.  Whether or not someone is legitimately an independent contractor depends upon a set of well-defined rules.  And understanding these rules can save you a lot of headache with Uncle Sam.

The IRS uses Publication 15-A, Employers Supplemental Tax Guide (58 total printed pages), while the Department of Labor uses a more generalized, two-page document.  You can click on the links to learn more about these tests. Whichever test you use, it boils down to 3 simple factors:

Factor #1: Behavioral

Does the company control or have the right to control what the worker does and how the worker does his or her job?

Let’s use an example.  Suppose you operate a nonprofit daycare and you have a clogged drain in the kitchen area.  What do you do?  You call a plumber, of course.  It is very unlikely that you will stand over the plumber and instruct him on how to fix your drain.  No, you called a professional for a reason.  He knows how to fix your clog!  You may have some input or preferences, but for the most part, he is in control of what he does and how he does it.

Conversely, if you hire a part-time administrative assistant, it is very likely that the balance of control lies with the organization, not your new hire.  The assistant is told when to come in everyday, how long to stay and what the job expectations are…even to the point of being trained in how to do most every aspect of the job!

Factor #2: Financial

Are the business aspects of the worker’s job controlled by the payer?  These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.

In our example of the plumber, what is the likelihood you will be supplying the plumber with tools to open your drain.  Not very likely.  Your assistant, on the other hand, probably won’t be expected to supply her own phone and computer.

Another financial consideration involves the element of risk.  Contractors have opportunity to experience financial loss, whether it be from underbidding a particular job or simply running his or her business in the red.  Employees are not generally exposed to the potential for loss.  If they have a job, they get paid.

Factor #3: Type of Relationship

Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

When the plumber is finished, you will be invoiced. He decides the fee. You may or may not have an ongoing contract with him for future services, but the relationship is clearly one of professional and client. I’ve yet to meet many administrative assistants who bill for their services at a fee they determine.

Who Cares The Most? The State or the IRS?

Well, both actually.  As mentioned above, the IRS and the US Department of Labor both have written guidelines they publish explaining how federal employment law is to be administered.  That said, your State Department of Labor cares, as well.

The classification of employee vs. contractor impacts state employment taxes, including unemployment insurance that is due for employees, but typically not contractors.  This is of particular interest because unemployment taxes and benefits are exclusively a state concern with regard to 501(c)(3) organizations.  They are exempt from federal unemployment taxes.

One more note to point out on this…In our experience, we have found that most issues nonprofits run into concerning misclassification of employees is first at the state level.  The state is far more likely to become aware of misclassifications.  This often happens when a former employee files a state unemployment claim, but they have been treated as an independent contractor improperly.

Penalties for Misclassification

The penalties for classifying an employee as a contractor can be severe.  At the state level, the Labor Department will usually reclassify the wrongly-treated contractor(s) as employees, retroactively to their first employment.  In addition, the state will assess back taxes for unemployment insurance, plus penalties and interest.  We’ve seen businesses bankrupted by this alone.

At the federal level, the worker reclassification will result in employer liability for not only the employer-portion of Social Security and Medicare not paid on behalf of the employee, but many times the Social Security Administration and the IRS will also hold the employer responsible for the portion not withheld from the worker’s paycheck.  You can imagine the consequences.  If the state-levied back taxes for unemployment didn’t bankrupt you, the IRS-levied back taxes for FICA probably will.


The reality is, it isn’t that complicated. People just want to make it that way. And the game they are playing by treating employees as contractors will catch up with them eventually…and when it does, it will be very, very expensive indeed. Don’t take chances that can greatly harm your nonprofit. It’s not worth the risk to either your organization’s finances or reputation.

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Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

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