As you probably know, the state requires any employer with more than 2 employees to have workers compensation (work comp) insurance. If you have less than 3 employees you may still decide to purchase work comp coverage. Other states may be different.
Workers compensation covers one of two things, either:
– Medical expenses and lost wages for on-the-job injury or illness or disease contracted as a result of employment; or
– If an employee elects not to get coverage under the first part, then workers compensation covers “employers liability” because your employees have the right to sue for on-the-job injury or illness or disease contracted as a result of employment

Important to note with regards to the first part (medical expenses) of workers compensation is that personal health insurance companies have the right to decline coverage for on the job injuries/illness/disease. In the state, sole proprietors and 10+ percent owners of LLCs and Corporations have the right to “affirmative election” of their right to refuse to be covered by their own workers compensation coverage. In some special classifications of work, the state is no longer allowing owners to exclude themselves, or requires a letter from the state specifically allowing an owner to exclude themself.

The state mandated minimum limit is $100,000 per employees per year (policy period). If you’re thinking about workers comp coverage, then you should also know that Workers compensation is annually auditable from your insurance company. That means they will send you documents requesting bookkeeper verification of your payroll and contractor expenses in order to correct your coverage “basis,” and to retroactively bill or credit you accordingly. You are required to respond with certified, accurate figures in a timely manner to these audits as a provision of your insurance coverage.

Auditing of W-2 employee payroll is pretty clear – payroll fully counts, with the sole exception of 10+% owners having the right to opt out from work comp coverage.

For contractors, there are options:
– Companies that you hire as contractors (who themselves have more than 2 employees) are responsible for their own work comp – so not your problem, though it is wise of you to retain a certificate of coverage for their work comp in your files.
– Sole proprietors (individual people) or single-entity LLCs whom you hire (usually as 1099 individuals) must have one of the following:

– They may provide you with an election to decline coverage form (PDF for Sole Proprietors;   PDF for LLC 10+ percent owners ), which must be notarized and you keep on file. The forms linked in this section are samples in 2010 from the state of New Mexico (look at the bottom of the page on that link for the Special Election forms) – contact the workers compensation administration (look on their website!) in your state for up to date forms.
– They may have their own work comp coverage already. If so, then they need to give you a certificate proving it
– If neither of the above two items apply, then YOUR annual work comp audit will require you to report those contractors AND to pay full value workers compensation on them. In some cases, like if they want to be covered for on the job injury by you, then this may be exactly what and how you want to cover them.

So, if a person who is a contractor working for you, both:
a) Does not have work comp coverage; AND
b) Is an individual and does not want work comp coverage

Then you need to keep the affirmative election for a Sole Proprietor to decline coverage, notarized, on file for them.
The work comp insurance company has the right to verify that you have these forms on file.