How the IRS Classifies Independent Contractors The Internal Revenue Service scrutinizes the use of contractors carefully, so don't let worker-classification rules trip you up or you could wind up extra taxes, penalties and interest. Here's how to avoid tax problems with 1099 workers.

You may decide your business can't afford to hire too many full-time employees, and you'd like to use the services of an independent contractor. With an independent contractor, you don't have to withhold and pay the person's income, Social Security and Medicare taxes.

While independent contractors do translate to lower payroll costs, be advised that the Internal Revenue Service scrutinizes the use of contractors very carefully. The IRS wants to make sure that your workers are properly classified and paying the government the necessary income and payroll taxes that are due.

To stay out of hot water with the IRS, be sure the workers you classify as contractors meet the IRS definition of an independent contractor. The determining factors fall into three main categories: behavioral control, financial control and relationship of the parties. The IRS uses 20 factors when deciding a worker's status. Here are some of the major ones:

• Who has control? A worker is an employee if the person for whom he works has the right to direct and control him concerning when and where to do the work. The employer need not actually exercise control; it is sufficient that he has the right to do so.
  
• Right to fire. An employee can be fired by an employer. A contractor cannot be fired so long as he or she produces a result that meets the specifications of the contract.
  
• Training. An employee may be trained to perform services in a particular manner. However, contractors ordinarily use their own methods and receive no training from the employer.
  
  
• Set hours of work. Workers for whom you set specific hours of work are more likely to be employees. Contractors, on the other hand, usually establish their own work hours.

To stay on the right side of the IRS, it is best to document the relationship you have with any contractors in a written contract. This can be a simple agreement that spells out the duties of the independent contractor. The agreement should state that the independent contractor, not the employer, is responsible for withholding any necessary taxes. In addition, have the IC submit invoices. It's a good idea to have a copy of the contractor's business license and certificate of insurance as well as his or her business card. Also, be sure you file Form 1099-MISC (Miscellaneous Income) at year-end, which is used to report payments made in the course of a transaction to another person or business that is not an employee. By law, you are required to file and give someone Form 1099 if you pay that person more than $600 a year. The form must be given to the IC by January 31 of the following year. Form 1099 with its transmittal Form 1096 must be filed with the IRS by February 28 of the following year.

Whether an individual is determined to be an independent contractor or an employee, it is required that you obtain their complete name, Social Security number and address before any money is paid. If this information is not obtained, you are required to withhold backup withholding taxes for federal income taxes.

If the IRS finds you have misclassified an employee as an independent contractor, you will pay a percentage of income taxes that should have been withheld on the employee's wages and be liable for your share of the FICA and unemployment taxes, plus penalties and interest. Even worse, if the IRS determines your misclassification was "willful," you could owe the IRS the full amount of income tax that should have been withheld (with an adjustment if the employee has paid or pays part of the tax), the full amount of both the employer's and employee's share of FICA taxes (possibly with an offset if the employee paid self-employment taxes), interest and penalties.

Be advised that there is some relief being offered. If a business realizes it is in violation of the law regarding independent contractors, it can inform the IRS of the problem and then properly classify the workers without being hit with an IRS assessment for prior-year taxes.

Related: How to Determine Your Working Capital Needs