A Few Tips for Small Business Owners on Structuring Independent Contractor Relationships

Given the potentially disastrous consequences of misclassifying workers—especially considering recent developments under Virginia law that shift certain presumptions against business owners and create private rights of action relating to worker classification issues—every independent contractor relationship should be carefully analyzed, structured, and documented.

I. Preliminary Due Diligence

Before entering into the working relationship, the hiring company should obtain some basic information and supporting documentation from the prospective contractor, including:

• the structure of the independent contractor’s business (e.g., sole proprietorship, limited liability company, corporation, etc.);
• whether the independent contractor has employees of its own or itself subcontracts its labor;
• whether the independent contractor performs similar services for other companies;
• whether and where the independent contractor maintains an office (other than the contractor’s home);
• how and where the contractor markets and advertises its services;
• the types of insurance coverage maintained by the independent contractor; and
• the contractor’s Federal employer identification number (“EIN”).

If the information obtained demonstrates to the hiring party’s satisfaction that the prospective worker meets basic prerequisites to qualify as an independent contractor and that the work to be performed suits the criteria for an independent contractor arrangement, the next step normally is to document the relationship in an independent contractor agreement.

II. Documenting the Independent Contractor Relationship

The agreement memorializing the business relationship should, at a minimum, address the following issues:

• the term or duration of the relationship (which ideally should be tied to the duration of the project for which the worker is retained);
• the nature and scope of services to be provided (which should be distinguishable from those services performed by a company’s employees);
• the manner and conditions for payment of compensation (e.g., a monthly fee or fixed sum upon completion of the project or identified milestones);
that the service provider is an independent contractor and not an employee;
• that the independent contractor will not be eligible to participate in any employee benefits;
• that the independent contractor, and not the company, will be responsible for payment of all applicable taxes and withholdings;
• that the independent contractor will provide his or her own workers’ compensation coverage;
• what other insurance coverage the independent contractor is required to carry for the duration of the relationship;
• that the contractor is free to set his or her own hours of work and to determine in what manner and sequence the work should be completed;
• that the independent contractor will supply and use his or her own equipment;
• that the contractor will be required to pay his or her own business expenses;
• that the independent contractor is free to hire his or her own employees;
the conditions on which the relationship may be terminated and the consequences of early termination, including any notice requirements and potential penalties;
• any desired indemnification (e.g., independent contractor’s agreement to indemnify and defend the company in the event of loss, damage or liability caused by the contractor’s own negligence); and any desired dispute resolution provisions (e.g., mandatory mediation, arbitration, etc.).

III. Day-to-Day Management of the Relationship

Even the most well-drafted contract has little value if it does not accurately reflect reality. Companies should make every effort to grant independent contractors the level of independence required to preserve the integrity of the independent contractor classification. Whenever possible, the independent contractor should be a separate, independent business entity. Ideally, contractors should be able to set their own hours, have freedom in selecting the site at which work is performed and be free to offer their services to other potential clients. Day-to-day supervision and direction of the contractor’s work in particular should be minimized, if not avoided altogether.

Contractor work assignments should not be identical to those given to employees. Rather, business owners should carefully and clearly define projects designated for independent contractors and set specific start and end dates to the extent possible. Any internal evaluation of the performance of independent contractors should focus on the quality and acceptability of the final work product rather than the manner in which it was produced. Under no circumstances should an employer use its employee performance review process to evaluate the work done by an independent contractor. It is also advisable to require independent contractors to provide periodic progress reports and to submit regular invoices for payment. Moreover, independent contractors should not be paid as part of the company’s regular employee payroll.

Where it is not possible in practice to conform the relationship to the legal requirements, employers may wish to consider alternatives such as re-documenting the relationship to align it with applicable standards or retaining a third-party staffing company. Although not necessarily a one-size-fits-all solution, the use of third-party staffing organizations can meaningfully reduce liability risk for worker classification issues under many circumstances, while at the same time day-to-day management of the relationship.

For specific guidance on how the IRS analyzes worker classification issues, check out IRS Publication 15-A, Employer’s Supplemental Tax Guide (2020), which can be found here.