It sounds like a great deal – instead of putting Fred on the payroll, the company hires him as an independent contractor (“IC”). The company avoids having to withhold income taxes, withhold and pay Social Security and Medicare taxes, and to pay unemployment taxes on what Fred earns. Fred likes it because his check is bigger than it would be if he were a regular employee. But there is a catch, many IC relationships are not legally valid, a lesson that employers are learning the hard way as they face tax audits and lawsuits with potentially huge payouts.

Whether someone is an IC or an employee of your company is not determined simply by which name you call them. In fact, the method to determining whether an individual is an IC or employee is based upon a litany of factors that can be somewhat complicated. These factors fall under three basic groupings – Behavioral Control; Financial Control; and Type of Relationship. The behavioral control group includes facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired. The financial control group includes facts that show whether the business has a right to control the business aspects of the worker’s job. The type of relationship group includes facts that show the parties’ type of relationship. The IRS lists factors under each of these groups in IRS Publication 15-A.

In general, under federal and state laws, an independent contractor must be just that – independent. He or she must provide a product or service without punching a time clock or being told how to do the job. Laws governing ICs, designed to protect workers from being short changed, have drawn increasing scrutiny and significance with the growth of the contingent workforce in recent years.

Most investigations are triggered not by a government agency, but by an employee who is aggrieved. It’s not uncommon for a worker whose contract period has ended to apply for unemployment insurance benefits with a state or local agency, or the individual seeks worker’s compensation benefits because of an injury. When the government agency doesn’t see any earnings reported, that may lead to an investigation into whether the worker was properly classified as an IC or whether he/she was really an employee. If a company incorrectly treats a worker as an IC, the company may be liable for all of the unpaid benefits, overtime, taxes, penalties and interest.