SMB Risk Management: How to Avoid Turning Your Contractor Into an Employee

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1. Feature: SMB Risk Management: How to Avoid Turning Your Contractor Into an Employee. (5 min read)

2. From the Archive: Should Your LLC Elect S Corporation Status? The Real Deal. Read it here.

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(Part 2 of our series—read part 1 here)

Small and medium-sized businesses (SMBs) frequently engage independent contractors—like programmers or marketing consultants—to access specialized skills without the cost of full-time employees. These arrangements offer flexibility and savings, perfect for a startup building an app or a retailer launching a digital campaign.

But when contractors work consistently, the line between contractor and employee can blur. That blur brings risk.

Misclassification by the IRS, Department of Labor (DOL), National Labor Relations Board (NLRB), or state agencies can result in penalties, back taxes, and lawsuits. The fix? A well-drafted independent contractor agreement that defines the relationship clearly.

This article outlines six key legal and operational concerns SMBs face when hiring consistent contractors—and shows how specific language from our template helps prevent the most common (and costly) problems.

1. Misclassification as an Employee

Problem: The longer and more regular the engagement, the more likely regulators are to reclassify your contractor as an employee. The IRS looks at “right to control” factors. The DOL’s 2024 “economic realities” test focuses on dependence, control, and integration. The NLRB adds complications if the contractor is embedded in operations. State rules, like California’s AB5 law, are even tougher—requiring that contractors work outside your core business, operate independently, and not be controlled.

If your programmer codes weekly with your team or your consultant joins recurring staff calls, you’re edging into employee territory. That can trigger unpaid tax liabilities, overtime claims, or fines—like California’s $5,000 to $25,000 per violation.

Solution: Establish independence from the start. Spell it out in the contract. Emphasize autonomy in how work is done, who controls the tools, and the ability to serve other clients.

Language:

“Contractor is an independent contractor, not an employee, agent, partner, or joint venturer of the Company...”

“Contractor shall have sole discretion over the means, methods, tools, and schedule...”

2. Tax and Benefit Liabilities

Problem: If the contractor is reclassified, you could be on the hook for their unpaid payroll taxes, workers’ comp, or even retroactive benefits. The risks increase if your contractor gets perks like team swag or if they don’t handle their own tax filings.

Solution: Make tax obligations crystal clear. Assign all tax and insurance responsibilities to the contractor and ensure the contract rules out eligibility for benefits.

Language:

“Contractor is solely responsible for all federal, state, and local taxes...”

“Contractor shall indemnify and hold the Company harmless...”

“Neither Contractor nor its personnel are eligible for Company benefits...”

3. Perception of Permanent Employment

Problem: A long-term or automatically renewing contract signals permanence—something both the DOL and NLRB consider red flags. That programmer who’s been on retainer for three years? They may be viewed as de facto staff.

Solution: Use fixed-term contracts with no auto-renewal. Make clear that the relationship can end at any time.

Language:

“This Agreement begins on the Effective Date and continues for [SPECIFY DURATION]...”

“This Agreement shall not automatically renew.”

“Either party may terminate this Agreement with [30] days’ prior written notice...”

4. Intellectual Property Disputes

Problem: If you don’t establish IP ownership up front, a contractor could claim rights to the work they produce. That’s dangerous if you rely on proprietary software or marketing content—and even worse if they reuse it for a competitor.

Solution: Lock down ownership. Make it a work-for-hire agreement and require assignment of all IP rights.

Language:

“All work product created by Contractor... is a ‘work for hire’ owned by the Company...”

“Contractor assigns all rights... and shall execute any documents necessary to perfect such ownership.”

5. Confidentiality Breaches

Problem: Contractors often access your sensitive data—client lists, codebases, marketing plans. Without strong confidentiality terms, they can walk away with your secrets or accidentally leak them.

Solution: Require strict confidentiality, enforceable even after termination. Include language that supports quick injunctive relief if necessary.

Language:

“Contractor shall not disclose or use any Confidential Information... except as necessary to perform the Services...”

“Contractor shall return or destroy all Confidential Information upon termination.”

“A breach of this Section 5 shall entitle the Company to seek injunctive relief...”

6. Costly Litigation and Class Actions

Problem: If a dispute arises, or worse, if a group of contractors file a class action over misclassification, the legal and reputational costs can be enormous—especially in states like California and New York.

Solution: Require binding arbitration, include a class action waiver, and maintain confidentiality. Allow court access only for immediate relief like IP theft or confidentiality breaches.

Language:

“Any dispute... shall be resolved by final, binding arbitration administered by the American Arbitration Association...”

“All claims must be brought in an individual capacity, not as a class...”

“All arbitration proceedings and outcomes shall be confidential...”

Why a Great Template Matters

Hiring contractors gives your SMB flexibility—but consistent work invites legal scrutiny. Misclassification can lead to fines, back taxes, or worse. Intellectual property and confidential data can walk out the door. Disputes can go public.

A great template addresses these risks head-on with real protection:

• Autonomy: “sole discretion over the means, methods, tools, and schedule”

• Tax clarity: “Contractor is solely responsible...”

• Dispute efficiency: streamlined AAA arbitration

• Multi-state compliance: “If any provision is unenforceable, it shall be modified to comply with applicable law.”

Practical Tips for SMBs

• Reinforce independence: Have contractors invoice through their own business, use their own tools, and work offsite when possible.

• Avoid integration: Skip the company email address and employee-style onboarding.

• Know your state rules: States like California and New York have strict tests—check with local counsel.

• Limit permanence: Hire for a project, not indefinitely.

• Review annually: Keep agreements up to date with federal and state rule changes.

Conclusion

A programmer coding your platform or a consultant boosting your brand can help your SMB grow—but the legal line between contractor and employee is thinner than you think. Misclassification risks taxes, penalties, and lawsuits. IP and confidentiality lapses can derail your business.

A great Independent Contractor agreement brings clarity with phrases like “no employment relationship” and “work for hire,” and it helps you resolve disputes before they explode.

The best time to protect your business is before there’s a problem.

Have an interesting business question and need a free bit of advice? Send your question to [email protected]. No confidential info, please!