All About LLCs And Their Flexibility
Loyalty, stability and the ability to terminate at will are key factors in hiring—but do they apply to every business entity? Companies structured as LLCs have greater flexibility in hiring than corporations and other standard business entities. Could your LLC benefit from hiring independent contractors?
What is an LLC?
An LLC (Limited Liability Company) is a unique business structure with both the limited liability of a corporation and the benefits of a pass-through tax structure similar to a partnership or an limited liability limited partnership. (LLLPs)
LLCs are widely used in the United States. As of 2021, there were nearly 2.5 million LLCs in the country, and that number continues to grow as entrepreneurs seek the liability shielding that this business form provides while coming under less regulation than other business structures.
LLC Structure
In terms of governance , an LLC is similar to a corporation in that it needs a board of directors and officers to direct and run the company; however, unlike a corporation, LLCs are not regulated by corporate law.
Flexibility of the LLC
The flexibility that LLCs have in hiring comes in different forms. On the surface, it seems that corporations and LLCs have the same flexibility—with both being able to employ independent contractors and pay them without withholding FICA.
However, if you dig deeper you find that because LLCs are different from corporations—at least by default—they have greater flexibility in their overall structure that can help in hiring decisions. For example, an S Corp or other business entity used for smaller ventures can only hire employees for their companies. An LLC, through its talk management structure, can hire contractors, employees, managers, and even officers.
What Is An Independent Contractor?
As you might guess from the name, an independent contractor is not subject to some of the same control that you have over your employees. An employee is your hireling: they have to do your work and you tell them how you want it done. An independent contractor does the work you ask of them, but they do it according to how they want and according to their own plans. They show up when they want and leave when they’re done. They work on multiple projects or jobs or clients at the same time. They send you invoices, not paychecks.
It’s not too hard to see the appeal of independent contractors for businesses: they’re ordered, sometimes pesky, other times just slow to finish their work. A hard worker isn’t necessarily one you want around every day and all the time. Plus, contractors can be hired or dismissed when you need them. Full-time employees represent a greater commitment than many businesses are ready for or need, such as a LLC.
And as we mentioned above, you want to be careful about fulfilling the obligations you owe to employees without getting yourself in trouble with the IRS by crossing the line and turning contractors into employees, which could cost you a pretty penny.
The Legalities Of Hiring Independent Contractors
When an LLC decides to use an independent contractor, the owner should understand the legal aspects of this type of arrangement. An LLC that uses independent contractors must abide by federal and state tax laws when hiring the services of an independent contractor. The Internal Revenue Service (IRS) requires that the LLC properly classify an independent contractor under a sole proprietorship, corporation or partnership business structure. Properly classifying an independent contractor helps protect the LLC from a lawsuit if the independent contractor violates laws and regulations for that state or federal agency, labor union, etc.
A contractor agreement, or independent contractor agreement, is a written contract between the LLC and the independent contractor that describes the details of the relationship. A written agreement is not required by law, but is highly recommended if the LLC intends to hire an independent contractor. The written independent contractor agreement should have the following basic elements:
Limited Liability Companies (LLCs) should be aware of the tax implications associated with a contractor agreement. They should maintain an ongoing relationship with a knowledgeable CPA who understands independent contractor and employee requirements. The IRS does not require an LLC to withhold income tax for independent contractors. LLCs are responsible for their own federal income tax payments as well as self-employment taxes, unless the LLC has a corporate tax choice for either S corporation or C corporation taxation. However, the LLC may withhold income tax if it is agreed to in the contractor agreement.
In addition to regular Federal Income Tax, LLCs may be required to pay federal unemployment tax. Federal Employment Taxes consists of two different taxes: Social Security for both the employer and employee portion and Medicare. A Medicare tax rate of 1.45 percent is withheld from the employee’s gross salary. No employer share is required.
When hiring independent contractors, the employer should prepare IRS Form 1099-MISC, Miscellaneous Income, for each individual hired. Any independent contractor who received compensation of $600 or more during the previous tax year from the company must receive a 1099-MISC form. This form can be downloaded online through the IRS Website. Employers should send the form to the contractor by January 31 of every year, and file it with the IRS by February 28 of every year. Independent contractors who do not receive a 1099-MISC form by January 31 of every year can use the form as a defense in dispute resolution negotiation.
Benefits Of Using Independent Contractors For Your LLC
For small- and medium-sized companies, an LLC hiring independent contractors is beneficial. LLCs commendably save money and time when they outsource some work to subcontractors. As hiring employees can be inexpensive, having outside specialists help your business accomplish certain projects saves cash in the long run. This is particularly true if your company only needs an employee to complete a project for a limited time. An LLC saves money when they fill positions with contractors instead of full-time workers. The amount of tax that goes into finances associated with permanent employment versus self-employment varies. Because independent contractors are not on your company’s payroll, you don’t have to worry about health insurance, social security, retirement accounts, unemployment insurance and everything else that goes into being a full-time employer.
Having contractors come in to help with projects gives LLCs flexibility when it comes to coverage. If you have several consultants working with the company, these individuals can be hired on as needed and then given the boot when the need is filled. It is easy to get help for short terms and then disconnect once the project is complete. LLCs benefit from this agility because it better enables them to conquer unpredictable micro-changes or sudden economic shifts.
The ability to get people with specialized skills is another reason that hiring contractors is a way for LLCs to save money. It isn’t unusual for small businesses to hire one or two permanent employees with specific skills. But what happens if the company needs help with a one-off project that suddenly pops up? Having to find a skilled employee on short notice – and pay them full-time money for a short-term job – would put a serious financial strain on most companies.
When you go through a temporary-consultant agency, you can find someone who can show up when you need them. These people are usually either freelancers or self-employed individuals who are also looking for contract-based work. When the LLC finds someone who possesses the skills they need, they save money by paying for the project at hand without bringing someone on board full-time.
If a contractor messes up or takes on more work than the LLC initially agreed to, then the consultant handles the cost. The company pays for the mistakes or overages and can use that information to incorporate the need for additional work going forward.
There is less liability when LLCs hire contractors. Mistakes happen, and workers get injured. Your company can be held liable for the things its employees do and where they do them. For instance, if an employee causes a car accident while he or she is on the clock, your company could be expected to help cover some or all of the damages.
Because contractors are self-employed, they bear this responsibility. They have their own insurance. And if they make a mistake, they have to pay for those damages out of their own pockets. Just like with employees, it would cost much more to hire the contractor than a worker who causes accidents and errors on the job.
Cons Of Hiring Independent Contractors
Just because using an independent contractor is an option doesn’t necessarily mean you should try it out. In fact, there are challenges and real risks associated with hiring an independent contractor that may make it less desirable.
One of the biggest challenges is correctly classifying a worker as an independent contractor instead of an employee. There can be severe legal consequences for misclassifying workers, as that turns them into employees entitled to the normal benefits and protections of federal and state employment laws. There’s not even a clear distinction between the two in all cases, because some workers do some parts of their jobs as employees and other parts as independent contractors. This is especially true of lawyers and many types of business professionals.
One of the biggest risks here is IRS audits. The IRS will regularly conduct audits of employers, so it’s best to assume they will be checking on the type of employment you have for various workers at a point in the future.
Beyond that, the IRS also has some strict time limits in place for how far back it can collect on unpaid payroll taxes. If you have been misclassifying workers and the IRS finds out about it, the amount of taxes owed will actually be enormous . The IRS will go back and impose those taxes going forward in increments of up to three years into the past. So, if you’ve been misclassifying workers for the last few years, the results could be crippling to your business.
Misclassification can also have substantial legal repercussions, as employees are able to file lawsuits against employers and the Department of Labor can investigate those cases. There are many lawsuits being filed today about misclassification in nearly every industry you can think of. Some workers are quite skilled at filing misclassification claims, and this is not a battle you are going to want to have to endure.
The risk of having misclassified workers develop a sense of dependency on your business is another challenge, as misclassified workers might expect to have C-suite employee benefits, and might come to expect ongoing work with your business. Some might even come to expect employment once they’ve given you their services for a certain period of time.
Because of these risks, you’ll want to consider various alternatives to independent contractors when attempting to reduce the costs you face as a business. For example, you could bring on interns or volunteers to help out within your business, or you could hire part-time employees.
Best Practices For LLCs Hiring Independent Contractors
When hiring an independent contractor, LLCs should follow a number of best practices to avoid misclassification issues and to ensure that both the purchaser and the contractor are protected. First, each contractor should be supplied with a clear contract setting out the terms of the relationship. The contract should specify the contractor’s expected performance on duties and obligations. In addition, if the contractor will be rendering services as a qualified professional, then the contract should clearly define the scope of those services. Other contractual provisions, such as confidentiality and non-compete clauses, should also be included whenever appropriate.
In addition, it is essential for the LLC to determine whether the IRS regulations have been complied with. While most of the IRS "safe harbors" for independent contractor status do not apply to LLCs, contractors that do not satisfy them may still be considered employees. If the contractor fails to meet all of the criteria, the LLC should consider withholding employment taxes or whether it can satisfy one of the IRS "reasonable basis" exceptions. Moreover, LLCs should be careful to avoid any "red flags" that could cause a compliance issue and should avoid providing employees with 1099 forms.
Finally, it is critical for LLCs to make sure that all terms and conditions of their contract are followed by the LLC and the contractor and that the relationship is documented. This can be accomplished by proper record-keeping of contracts, communications, and payments between the LLC and the contractor, along with closely monitoring the relationship and any problems that arise.
Final Take – The Best Choice For Your LLC
The final decision as to whether your LLC should hire an independent contractor shouldn’t be based solely on the legal definitions. The broader implications on your business have to be considered as well, so you can ensure that your company is in compliance and that you are getting the most value from any contractors you work with.
If your industry tends toward hiring W-2 employees, that might be the best option . If you’re working on a project basis or in a space that doesn’t rely as much on full-time employees, contracting might be a more sensible route.
While it may be tempting to try to have a contractor do as much as possible, it’s not a smart way to save on labor costs in the long run. You could find yourself in serious legal trouble as a result of treating a worker as an independent contractor who should be classified as an employee. This is why it’s so important to get legal advice about how to classify each worker who interacts with your business.