Monday, February 16, 2009

Employees vs. Consultants: What a Start-Up Should Consider

Should a start-up consider classifying its workers as consultants rather than employees? Generally this is a bad idea. However, it is common for a start-up to classify its founders or other employees as consultants in order to avoid withholding taxes from their (typically limited) pay checks. More below the fold.

The IRS does not really pay attention to your justifications for classifying a particular person as a consultant and filing 1099s. Instead, they are going to look at how much control the company has over the person you claim is a consultant. Too much control = not a consultant. This matters because, if the IRS determines that someone you have been treating as a consultant is actually an employee, then the company will have liability for taxes that were not withheld as well as potential liability for interest and penalties.

This is precisely the sort of issue that will give a venture capitalist an excuse not to invest in your business. These sorts of issues are pretty obvious during the diligence process and the VC will require that all of this is cleaned up before they entrust you with any of their LP's money.

A natural question would be -- what about my actual consultants? How can I tell and ensure that they will get the correct "consultant" treatment. To answer this, I have always used a 20 question test that distills the IRS rulings in this area, I have included in parenthesis the answer you want to hear if you want to classify this person as a consultant.

1. Is the consultant required to comply with your instructions as to when, where, and how the work is to be done? (No.)

2. Did you provide the consultant with training to enable him to perform his job in a particular method or manner? (No.)

3. Are the services the consultant provides integrated into your business operation? (No.)

4. Must the services be rendered by the consultant personally? (No.)

5. Does the consultant have the capability to hire, supervise, or pay assistants to help him in performing the services under contract? (Yes.)

6. Is the relationship between the consultant and your company a continuing relationship? (No.)

7. Who sets the hours of work? (The consultant does.)

8. Is the consultant required to devote his full time to the your company? (No.)

9. Does the consultant perform the work at your company's place of business? (No.)

10. Who directs the order or sequence in which the consultant works? (The consultant does.)

11. Is the consultant required to provide regular written or oral reports to you? (No.)

12. What is the method of payment - hourly, commission or by the job? (Fixed price, not-to-exceed, and/or milestone payments are generally standard for independent contractors.)

13. Do you reimburse the consultant for his business and/or traveling expenses? (No.)

14. Who furnishes tools and materials used by the consultant in providing services? (The consultant does. This includes workstation, internet access, etc.)

15. Does the consultant have a significant investment in the facilities he uses to perform his services? (Yes. The focus here is on the word "significant." Lots of employees have a home computer.)

16. Can the consultant realize both a profit and a loss from his work? (Yes-the consultant must assume risk based on whether you are satisfied with his work.)

17. Can the consultant work for a number of firms at the same time? (Yes.)

18. Does the consultant make his services available to the general public? (Yes. For example, the consultant should have business cards, stationery, invoices, and a business listing in the phone book.)

19. Is the consultant subject to dismissal for reasons other than nonperformance of contract specifications? (No.)

20. Can the consultant terminate the relationship without incurring a liability for failure to complete a job? (No. If the consultant works on a project or milestone basis, the consultant must deliver to receive payment for his efforts.)

You should note that no one of these factors is determinative. However, if you answered one or more of them incorrectly you should consider discussing the potential consulting engagement with your counsel. Also, when considering these factors, please note that your mileage may vary depending upon your situation and the state(s) in which you do business. Please consult an experienced employment lawyer if you are pondering a close call.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.