Startups: Tax Implications of Hiring Independent Contractors vs. Employees

September 28, 2022

By Erika Ballo

While the classification of an employee vs a contractor can often be a fine line, it’s imperative that your startup performs the necessary due diligence to make an accurate determination. In this video, you’ll learn about the three worker classification tests, filing requirements, and more to avoid possible tax and legal exposure


Transcript

Erika Ballo:

Across all industries, companies hire independent contractors. However this topic often comes up in the ultracompetitive tech and life sciences industries. In these industries, getting new therapies or new products to market quickly can mean the difference between achieving the next round of funding or failing. Optimizing workers to be ready to execute on a just-in-time basis can be a clear differentiator for a startup beating out its competition.

While some of the advantages may seem obvious — notably, not having to pay payroll taxes and unemployment taxes and access to workforce without a long-term commitment — businesses may face significant tax and legal exposure if worker classification fails to hold up under a federal or state challenge. Since I will only be discussing federal rules, it’s important to mention that state rules and requirements may be even more stringent than the federal rules, so please make sure that you understand them as well.

For federal purposes, if you have contractors working for you, there are three worker classification tests that you must be aware of: behavioral test, financial test, and relationship type test. Let’s talk about them separately:

  1. Behavioral – Does the company control or have the right to control the way a worker performs his/her work? Companies normally have this control with employees. However, a company hiring an independent contractor normally defines an end goal or product, which the contractor achieves as they see fit.
  2. Financial – Examine how the company controls the economics of the worker’s labor. Companies provide employees the tools to do their jobs. Employees are also guaranteed a regular wage weekly, bi-weekly or monthly, even if they receive commission. Contractors need to determine which tools to use and assume the costs and risks associated to complete the work. Independent contractors also work on an agreed-upon, fixed fee or cost/material basis.
  3. Relationship Type – A company typically develops a long-term relationship with its employees and provides benefits such as health insurance, retirement plan contributions and paid time off. Independent contractor relationships center on a project that has a definitive beginning and ending, and they do not receive any of the employee benefits described above.

Misclassification is often deliberate because it is cheaper to have a contractor instead of an employee. If a business classifies an employee as a contractor, then it does not have the expense of employment taxes such as Social Security, Medicare, and unemployment taxes. In addition, it does not have to include the worker in the company’s healthcare and retirement plans, if there are any. Thus, workers’ classification between employee and independent contractors continues to be a top issue for the U.S. Department of Labor and the Internal Revenue Service.

No one fact or circumstance is dispositive in reaching a conclusion. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor and no one factor stands alone in making this determination.

With that said, here is example: You are a retired physician, and you have an excellent idea to treat a disease which you think is worth pursuing. You contact one of your friends at a research university and you get in contact with a couple of grad students. You ask them to come help you run some experiments.. It starts out as approximately 10 hours a week but very quickly they are working on your project 30-40 hours a week. You tell them exactly what to do and you gave them high performing laptops. You expect them to work on your project and they rely on the hourly payment that you provide. In this case, these grad students are in fact your employees. They do the work for you under your direction, with your equipment. They should be classified as employees and issued W-2s.

If your classification of a worker as an independent contractor is challenged by an IRS audit or a contractor, you may be entitled to a Section 530 relief. You will not owe employment taxes if all three of the relief requirements are met. The requirements are more nuanced, but here is just a quick summary:

  1. Reporting consistency- you filed all 1099 Non-Employee Compensation (NEC) forms in a timely manner;
  2. Substantive consistency: you classified similar workers the same; and
  3. Reasonable basis: you must have a reasonable basis to treat a worker as an independent contractor based on a court ruling, an earlier IRS audit or industry practices.

Lastly, please keep in mind that there are filing requirements. If a worker is treated as an independent contractor, it is incumbent upon you or the company to issue a Form 1099-NEC to the contractor each January for the work performed during the previous year. With a few exceptions, this form must be issued for all unincorporated service providers who have received payments from the company that exceed $600. It is a good practice to obtain from the contractor a Form W-9, Request for Taxpayer Identification Number and Certification so that you have all the necessary data on hand.

While there can often be a fine line between what makes someone an employee or a contractor, it is imperative that you perform the necessary due diligence to make an accurate determination and avoid problems later with an IRS or state audits or a lawsuit from a disgruntled contractor.

About Erika Ballo

Erika Ballo is in the Private Client Services Group with over five years in both public and private experience.


More in This Series

Cybersecurity Risks and Solutions for Life Sciences Startups

Cybersecurity poses a significant risk to life sciences startups that handle personal identifiable information. In this video, you’ll learn about the risks facing your business and how you can protect your clients and systems.

When Do I Need to Get an IRC Sec. 409A Valuation for My Stock Options or Stock Grants?

A 409A valuation is used by private companies to assess the fair market value of their stock. In this video, you’ll learn when a 409A valuation is necessary, the length of time in which it is valid, and which events trigger the need for an update

Capital Raising: What Are My Options—and How Do I Approach Investors?

In this video, you’ll learn about various options for raising capital, tips for creating your potential investor list, and how to approach investors.

What Technology and Life Sciences Companies Need to Know about being Acquired by a SPAC

Becoming a public company through an acquisition by a SPAC is an alternative to the traditional initial public offering (IPO). In this video, you’ll learn some key considerations that a technology or life sciences company should keep in mind before being acquired by a SPAC.

Going Global: How to Report Your Foreign Operations for Tax Purposes

In this video, we’ll examine why reporting on foreign operations for tax purposes is an important matter for technology and life sciences start-ups doing business abroad.

What Tax Considerations Does My IPO Trigger?

Is your company preparing for (or have you recently had) an IPO? In this video, you’ll learn about the impact that an ownership change under IRC Sec. 382 can have on the utilization of net operating loss (NOL) carryovers and other factors that can influence your tax burden.

Medical Device Companies: Consideration for Consignment Inventory and Related Sales Process

Many medical device companies have chosen to deploy a consignment inventory and sales approach for their related products. In this video, you’ll learn about the advantages and disadvantages of this strategy for both the company and third parties, as well as best practices to consider

What Technology and Life Sciences Companies Need to Know About Transfer Pricing—from Start-ups to Large MNEs

In this video, you will learn why transfer pricing is an important focus point for many multinational enterprises in the technology and life science industry.

Capital Raising: Are Financial Instruments Classified as Liabilities or Equity?

In this video, you'll learn about the different accounting ramifications for financial instruments issued to investors by start-ups and why it’s important to properly structure financial instruments upfront for accounting purposes.

Financing for Entrepreneurs: What Are Issuance Costs?

In this video, you’ll learn about “issuance costs” and how to properly account for them based on the type of funding that was raised.

Does My Start-up Need an Advisory Board?

In this video, you'll examine the ways how an advisory board differs from a board of directors; why you might consider forming an advisory board; how you can attract and retain advisory board members; and how you can enhance the effectiveness of the advisory board for your start-up.

What Technology and Life Sciences Companies Need to Know About SOC 1 Reports

Brenda DeSaro explains what a SOC 1 Report is, discusses why companies need to be concerned about these reports even though they likely outsource this work to third-party providers, and outlines a best practices approach.

Entrepreneurship: Behind the Numbers

John Pennett talks about the ingredients for successful entrepreneurship—from early to late-stage enterprises—with “Behind the Numbers” host and senior director at CFGI.