In today’s gig economy, apps and online platforms make it easier than ever to hire freelancers on a project basis. Like many small business owners, you may view the use of independent contractors as an easy, flexible way to grow your business.
Before you do, however, be aware that this approach comes with some risks and obligations, especially where the IRS is concerned. To help you stay on the right side of the law, we gathered some expert advice from a tax professional as well as a labor and employment attorney.
To begin, there are three types of workers: W-2 employees, W-2 employees from a staffing agency, and 1099 independent contractors.
When you use a staffing agency to retain labor, this is a joint employment situation in which the agency pays the employee. If the agency doesn’t pay the worker properly, your business is jointly liable for any mistakes. Similarly, W-2 employees are paid by the company they work for. At the end of the calendar year, the employer must send the W-2 to the IRS and to the employee.
Freelancers, on the other hand, are nobody’s W-2 employee. Instead, they receive a 1099 at the end of the year indicating the amount of non-employee compensation they received.
“Independent contractors are treated as a standalone business, and they pay their own Medicare, Social Security and Workers’ Compensation,” said Todd Lebowitz, partner with Baker Hostetler. “The risk lies in the fact that a freelancer who is treated as an independent contractor might actually be your employee and you don’t know it.”
What’s the Difference Between Employees & Freelancers?
As a general rule of thumb, the difference between an employee and an independent contractor usually comes down to control.
“Does the employer have the ability to control what the person is doing and how they are doing it?” said Sara Goldhardt, director of state and local tax services at GBQ Partners. “Independent contractors do the work the way they want, in the hours they want, using their own tools and supplies.”
The following two tests are used to determine a worker’s status:
- Right to Control Test: “Used primarily for tax purposes, this test determines who has the right to control how the work is done,” Lebowitz said. “With a proper independent contractor relationship, you should be asking for results. You don’t care how, when or where they do it or if they hire helpers. All you care about is that a result is achieved by a certain deadline within certain specifications. The more you retain the right to direct how the work is done, the more likely it is that the person is an employee.”
- Economic Realities Test: The courts and Department of Labor use this test to determine if the worker is dependent on your business to earn a living, whether they have other clients, whether they’ve made a significant investment in their own tools, and more.
The consequences are severe for failing either of these tests, including substantial tax penalties and a possible lawsuit. “The IRS also looks at the permanency of the relationship,” Goldhardt said. “If the person has been doing the same job for three years, it looks more like a permanent position and not something for a contractor.”
Avoid These Common Mistakes in Classifying Workers
The following scenarios identify some common misconceptions about hiring freelancers and independent contractors as well as how to avoid them.
Short-term needs: You may be tempted to hire a freelancer to get through a temporary influx of work. “But if the independent contractor is doing the same things as regular employees, then the contractor is most likely an employee,” Lebowitz explained. “A short-term need is not a good reason to classify someone as a contractor.”
Solution: Hire a part-time employee instead. “It’s OK to have a part-time employee who works irregular hours or one who works for two weeks and then you don’t need them again,” Lebowitz said.
Work conditions: If you require the worker to be available in your office from 9 to 5, for instance, using your computer, wearing a uniform or adhering to other details of employment, he or she should be classified as an employee.
Solution: Let the freelancer work autonomously.
Reduction in business: Sometimes a company will convert an employee to a contractor due to a reduction in business. They reduce the person’s hours, but the work is the same. In this case, any employee with both a W-2 and a 1099 in the same year is a red flag for the IRS.
Solution: Convert the worker to a part-time employee.
Still not sure if your worker is an independent contractor or an employee? IRS Publication 15-A includes several examples of independent contractors by industry.
Follow the Freelancer Paper Trail
To help ensure that freelancers and other workers are correctly classified, make sure they’ve completed the right paperwork:
- Independent contractor agreement: You may want to get professional help to draft the agreement, especially since a generic template will not be adequate. The agreement should be customized, and it should highlight the facts that support contractor status. “It’s not a one-size-fits-all contract,” Lebowitz said. “You have to understand the right questions to ask about the relationship so you can highlight the facts that support contractor status in your state.”
- W-9 form: If you pay an independent contractor $600 or more in a calendar year, you must provide that person or company with a W-9 form. This form includes the contractor’s tax ID number, name and address, and it indicates that you don’t have to withhold income taxes.
- 1099 form: This form reports income from self-employment earnings. The business owner is responsible for completing the appropriate 1099 tax form and sending it to the contractor before January 31.
There may be plenty of times when it makes sense to work with a freelancer, especially when you need a skilled expert. But when deciding whether to hire a freelancer, focus on the facts of the relationship—not what you want to call it. “It’s the facts that matter, not the labels,” said Lebowitz.