It’s no secret employers are using freelancers (a.k.a. independent contractors) more than ever before. In fact, a 2015 study conducted by independent research firm Edelman Berland and commissioned by the Freelance Union and Upwork indicated nearly 54 million Americans are now doing freelance work. That’s great news for the sole proprietor, but also a reminder to the employer: There are tax implications when hiring freelancers, and it’s something to plan and prepare for before working with your tax adviser.
Classifying what constitutes a freelancer is confusing to many employers, especially those using freelancers for the first time, says Gail Rosen, of Gail Rosen CPA, a certified public accounting firm that provides a full range of tax and accounting services throughout Greater New Jersey and New York.
“When your business hires someone to work as a freelancer, you need to make sure they are in fact an independent contractor and that they are not really an employee,” says Rosen. “Workers who are misclassified as independent contractors (freelancers) are a prime example of tax target areas by the IRS, State and Departments of Labor. This has even become more of a target area under the Affordable Care Act and health insurance mandate.”
How the IRS Assesses Employee/Freelancer Status
The problem is that determining whether a worker is a freelancer/independent contractor or an employee does not have definitive answers. And the guidelines are different on the federal and each state level, says Rosen.
The IRS previously had a 20 common law factors test and tried to simplify it down to three main categories to determine if a freelancers is classified correctly:
- Behavioral control
- Financial control
- The relationship of the parties
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Each situation is determine on a case-by-case basis.
The Risks of Misclassifying Employees as Freelancers
“Classifying someone incorrectly, who should have been an employee, can leave to disastrous results as you can owe back taxes, penalties, interest and workers compensation,” says Rosen.
Businesses do not run the risk of getting caught by a chance audit, says Rosen. A freelancer can apply for unemployment or get hurt on the job which can lead to authorities investigating them.
“My suggestion is for businesses to set up paying a worker correctly from the beginning,” says Rosen. “This way they can negotiate how much they are paying the person with or without the payroll taxes, workers compensation and any benefits.”
How to Classify Your Staff: Employee vs. Independent Contractor
Mike D’Avolio, CPA and Senior Tax Analyst for Intuit, a software company that develops financial and tax preparation software and related services for small businesses, accountants and individuals, provides this breakdown to help employers understand the difference between employees and freelancers (independent contractors):
It may be tempting to classify an employee as an independent contractor because of the cost savings: Please don’t. There are strict rules surrounding the proper classification of a worker and steep penalties for failure to apply the law correctly.
Some businesses misclassify an estimated 10–60 percent of their workers as independent contractors and nearly 30 percent of firms misclassify contractors.
If you answer “yes” to any of the following questions, you’re likely hiring a W-2 employee and not a 1099 independent contractor:
– Will the work be performed on company premises?
– Will the individual work only for you?
– Will you provide tools and training for your worker?
– Do you control the hours the person works?
For employees, you need to withhold taxes, pay payroll taxes and file Form W-2 and W-3. These forms are used to report wages and is filed with the employee and the Social Security Administration.
For freelancers/independent contractors, such as attorneys and accountants, no withholding is required, but you need to provide the contractor and IRS with Form 1099-miscellaneous. This form is required when you make payments of $600 or more for services performed.
There are convenient electronic services like Intuit’s 1099 e-file that pre-fill your information and enable you to email or print forms for your contractors. This will avoid running to the office supply store to buy them.
Need help distinguishing between 1099 (freelance) and W-2 (employees) workers?
Take this 5-minute quiz from Quickbooks and Intuit to know the difference.
Thinking about hiring freelancers for your business? Sign up for a FlexJobs employer account and post your positions for free today!
Readers, are you looking at hiring freelancers or W-2 employees? What are your tried-and-true best practices for classifying your own employees and freelancers?
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