Contract Workers vs. Employees: What Businesses Should Know Credit: Garry L./Shutterstock

In today's "part-time economy," a growing number of workers are trading in the corporate hierarchy for the freedom to be their own boss. These independent contractors can be found in nearly every profession, from lawyers and business consultants to writers and yoga instructors. They set their own schedule and enjoy a wide variety of work experiences, but they also pay their own taxes and secure health insurance independently, which makes life much easier for the employers who enlist their services.

It's easy to see how a freelance or contract-based arrangement can benefit both workers and small businesses with a limited budget and human resources department. But depending on the specific terms of your arrangement with an independent contractor — hours worked, reporting structure, payment schedule, etc. — you may be in violation of some very serious worker classification laws.

Joy Child, a tax partner with Alexander, Aronson, Finning & Co., noted that a company wrongly treating its workforce as independent could be liable for payroll taxes, interest and penalties. Regular employees are entitled to certain legal protections and benefits that independent contractors aren't — and the IRS and state governments are actively looking for clues that a company might be shirking its responsibilities to its workers. [4 Labor Laws You Might Be Breaking]

"If there were lots of 1099s issued and very little payroll, that would indicate that there might be a problem," Child said.

In the '90s, Microsoft misclassified thousands of programmers and computer engineers as independent contractors. These long-term temp workers brought a benefits case against the company and were deemed by the courts as "employees." As a result, the company was required to pay millions of dollars in penalties and legal fees, and the case yielded a set of guidelines to help employers determine whether a worker is an employee or an independent contractor. Here are the most important factors to consider when determining worker classification.

Control over how work is done: Workers who work when and where they want to using their own methodologies and guidelines are rightly considered to be independent contractors. If, however, you require a worker to be in the office for a fixed period of time and work according to company policies, that person should likely be classified as an employee.

Equipment and software: Does the worker use his or her own computer, or does he or she use a machine on site? Does that machine have software on it that the worker does not have? Does he or she use company office supplies? An independent contractor should supply most or all of his or her own materials to complete a job.

Compensation: Freelancers are generally paid by the job. If a company pays a worker a monthly or yearly amount, the IRS will likely categorize that person as an employee. Remember, businesses need to send all independent contractors a 1099 form to report how much the company paid the person over the course of a year.

Training: Businesses shouldn't have to train independent contractors, according to the IRS and many state labor boards. Independent contractors should be able to begin immediately, producing work that they've been hired for. If a worker requires significant training, he or she may be considered employees.

Exclusivity: True freelancers are self-employed business owners. They often have their own website and business cards, and advertise their services to other companies. Asking the person to exclusively work for your company puts him or her closer to employee status.

Harley Storrings, a partner in the Fort Lauderdale office of Arnstein & Lehr law firm, noted that it's never just one of the above factors that classifies a worker as employee or contractor, and each of them must be taken into consideration. To do this, he strongly recommended that small companies, especially those without a designated HR professional, review a worker's terms of service with an attorney. Even if a misclassification is a genuine, unintentional mistake, it could cause your business a huge financial and legal headache.

"You're better off figuring out the proper classification from the get-go," Storrings said. "At the end of the day, you don't want to face an IRS audit or employee lawsuit. There [could be] fines, penalties, back taxes, additional compensation owed for overtime, etc. Find an attorney you trust and when you have an issue, reach out to them."

When hiring independent workers, Miranda Nash, president of recruiting software Jobscience, advised working with a professional staffing firm to reduce the administrative burden on you as an employer.

"It doesn't free [you] from liability, [but] staffing agencies are attuned to these questions," Nash told Business News Daily. "They know the rules and how to manage them."

If you're still not sure whether a freelancer should be considered an employee or independent contractor, the IRS will review your circumstances and make the determination for you when you submit Form SS-8. For more information on worker classification, visit the IRS website.

Additional reporting by Patrick Egan, Business News Daily contributor.

Originally published on Business News Daily on Mar. 5, 2011. Updated Oct. 1, 2014.

Correction: An earlier version of this article indicated that Harley Storrings was a partner at Arnstein & Lehr's Miami office, instead of Fort Lauderdale.