A murky area even by normal standards of law. The article goes through the conventional analysis of what constitutes a contractor versus an employee.
Here are some practical points (of more particular interest to startups) that go beyond the formal analysis:
1. IRS uses a list of "factors" that, in practice, is so nebulous that most large businesses do not fool with taking chances unless they can bring their contractors within a "safe harbor" area.
2. A 1986 tax act provided that tech service providers would no longer get safe-harbor treatment and this immediately caused large tech companies to retain contractors strictly (or at least largely) through a cottage industry of agencies that cropped up in response to the change. From that point on, if you wanted to hire yourself to a large tech company as a consultant, you had to go through an agency or else be incorporated so they could hire your entity instead of you personally. Microsoft paid dearly some years back when it had a whole slew of contractors reclassified as employees after years of treating them as contractors.
3. The basic idea of the IRS "factors" is to determine if a contractor is really in an independent business or if the classification is merely a veneer for employee-like activity. One of the worst killers on this issue is if you have longish-term contractors performing routine duties that are a regular and recurring part of your core activities as a company - that activity spells "employee" to the IRS.
4. Early-stage startups usually have fewer issues in this area than do established companies, not because they handle this issue correctly, but because they are less likely to get snagged in an audit. Even small companies can get snagged, though, e.g., when one of its contractors gets terminated and goes to file for unemployment. Generally, however, small companies do not issue enough 1099's in any given year to raise that particular audit flag and so tend to fly under the radar on this issue.
5. A trap in this area is not to document the relationship. If you don't have a written agreement specifying that the individuals are independent contractors, you lose on the issue. If you do have a written contract so specifying, you gain nothing except that you don't lose automatically based on the absence of a proper written agreement alone.
6. Even without the safe harbor, it is usually safe to hire independent contractors who truly are in the business of providing services to multiple customers. There is no special risk here and startups routinely use the services of such contractors without incurring any special risks.
7. After a VC funding, you will normally want to go with straight employees for your startup, with exceptions of the type noted in #6 above. In addition to avoiding the reclassification risks associated with contractors, hiring people as employees is more conducive to protecting the company's IP and also enables the company to use better incentives in the form of incentive stock options (ISOs), which are available only to employees.
8. If you are using a lot of "contractors" in your early-stage startup, be absolutely sure that your startup is a limited-liability entity. If contractors get reclassified, the liability generally attaches to the entity only and not to its management. Penalties can be large because, if you cannot track the contractors down and get them to certify that they actually paid their taxes on their 1099 income, the company is required to pay (in addition to normal payroll taxes) an amount based on the estimated income tax that such contractors should have paid on that income. For this reason, if you get an audit covering a few years and have more than a handful of contractors reclassified, the total tax/penalty hit can easily run into six figures.
9. Based on all of the above, don't take needless risks in this area. Get good professional advice and try to do it by the book.
I guess number two explains why I have heard of some companies keeping contractors around for a maximum of one year.
My brother worked for Apple doing tech support as a contractor for awhile and he said that once you had worked for a year you were either fired by the employment agency or hired as an employee of Apple.
Also, I'm working as a contractor this summer for a power company, and I've heard that it is policy that contractors can only stay for a year. One of my coworkers started as a contractor worked for a little over a year, and ended up getting fired for a few months until a full time position could open up and he could be hired as an employee.
Here are some practical points (of more particular interest to startups) that go beyond the formal analysis:
1. IRS uses a list of "factors" that, in practice, is so nebulous that most large businesses do not fool with taking chances unless they can bring their contractors within a "safe harbor" area.
2. A 1986 tax act provided that tech service providers would no longer get safe-harbor treatment and this immediately caused large tech companies to retain contractors strictly (or at least largely) through a cottage industry of agencies that cropped up in response to the change. From that point on, if you wanted to hire yourself to a large tech company as a consultant, you had to go through an agency or else be incorporated so they could hire your entity instead of you personally. Microsoft paid dearly some years back when it had a whole slew of contractors reclassified as employees after years of treating them as contractors.
3. The basic idea of the IRS "factors" is to determine if a contractor is really in an independent business or if the classification is merely a veneer for employee-like activity. One of the worst killers on this issue is if you have longish-term contractors performing routine duties that are a regular and recurring part of your core activities as a company - that activity spells "employee" to the IRS.
4. Early-stage startups usually have fewer issues in this area than do established companies, not because they handle this issue correctly, but because they are less likely to get snagged in an audit. Even small companies can get snagged, though, e.g., when one of its contractors gets terminated and goes to file for unemployment. Generally, however, small companies do not issue enough 1099's in any given year to raise that particular audit flag and so tend to fly under the radar on this issue.
5. A trap in this area is not to document the relationship. If you don't have a written agreement specifying that the individuals are independent contractors, you lose on the issue. If you do have a written contract so specifying, you gain nothing except that you don't lose automatically based on the absence of a proper written agreement alone.
6. Even without the safe harbor, it is usually safe to hire independent contractors who truly are in the business of providing services to multiple customers. There is no special risk here and startups routinely use the services of such contractors without incurring any special risks.
7. After a VC funding, you will normally want to go with straight employees for your startup, with exceptions of the type noted in #6 above. In addition to avoiding the reclassification risks associated with contractors, hiring people as employees is more conducive to protecting the company's IP and also enables the company to use better incentives in the form of incentive stock options (ISOs), which are available only to employees.
8. If you are using a lot of "contractors" in your early-stage startup, be absolutely sure that your startup is a limited-liability entity. If contractors get reclassified, the liability generally attaches to the entity only and not to its management. Penalties can be large because, if you cannot track the contractors down and get them to certify that they actually paid their taxes on their 1099 income, the company is required to pay (in addition to normal payroll taxes) an amount based on the estimated income tax that such contractors should have paid on that income. For this reason, if you get an audit covering a few years and have more than a handful of contractors reclassified, the total tax/penalty hit can easily run into six figures.
9. Based on all of the above, don't take needless risks in this area. Get good professional advice and try to do it by the book.