LLC or Sole Prop? Which Type of Independent Contractor Should You Prefer?

Is it better, for compliance purposes, if your independent contractor is operating as a business entity (e.g. LLC or Corp) rather than as a sole proprietor?  Yes, it is better…and definitively so.

First, as a simple matter of appearances, a contractor who looks like he or she is operating a business is more likely to be found to be a bona fide independent contractor. This is because when a contractor provides services as an LLC or Corp, it sends a clear message that the contractor intends to: operate a business; comply with the formalities of starting and maintaining a business; separate herself from the business and its liabilities; hold the business out to the world as its own entity, and not as an alter-ego of the contractor, etc. In short, the very act of providing services through an LLC or Corp telegraphs to the world, and to an auditor, that the contractor is its own business, and certainly not anybody’s employee.

Second, as a legal matter, the LLC or Corp designation can prove to be critical (dispositive, even) in the determination of whether a contractor is an exempt independent contractor or an employee/covered worker. This is particularly true of one state agency: Washington State Employment Security Department (ESD). As you may know, ESD administers our state’s unemployment insurance program, and audits businesses to ensure that employers are paying unemployment insurance on all employees/covered workers.  Accordingly, during an ESD audit, a business owner must be able to prove that her independent contractors are not, in fact, employees.  One way to prove this is by showing that the relationship with the independent contractor satisfies ESD’s exempt independent contractor test. This test, however, can be unforgiving, and business owners can easily fail, or at the whim of an aggressive auditor, be made to fail.

Another (an easier?) way to prove that an independent contractor is not an employee is by establishing that the contractor is providing services through a bona fide business entity, and not simply as a “natural person.” The reasoning for this is as follows: ESD recognizes that only individuals/natural persons can form an employment relationship, and as such, only individuals/natural persons can apply for and receive unemployment benefits. As a corollary, ESD recognizes that because a business entity can never qualify for unemployment benefits, an employer should not be required to pay unemployment insurance taxes on business entities it hires. Thus, where ESD sees that an employer has hired a business entity – including an independent contractor providing services through a business entity – ESD will presume that the business entity/independent contractor is not in employment. To be sure, this analysis has its limits and business owners should not presume that they categorically cannot be found to be employers of contractors providing services through an LLC or Corp. To the contrary. ESD is empowered to look at whether the contractor is truly providing services as a legitimate business, or whether the LLC or Corp is a sham entity disguising what is effectively an employment relationship.

There’s more to this conversation than can be addressed in this one post, but a reasonable overall takeaway is that there definitely is a compliance advantage to working with a contractor who provides services through a business entity. Just as important, however, is that you should not presume, based on this post, that the contractor’s business entity is your silver bullet. It absolutely isn’t. It is, as they say, but an arrow (or two) in your quiver.

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