Hiring a freelancer can be as simple as a handshake or short written agreement. But as a businessperson, you need to be aware that federal and state governments–on the prowl for higher payroll tax hauls–have been cracking down on companies that hire independent contractors but treat them like W-2 employees.
According to a 2013 study by the Treasury Inspector General for Tax Administration, 19 percent of employers failed to comply with IRS rulings on worker status–and each misclassified worker saves employers an average of $3,710 annually in Social Security, Medicare, and federal unemployment taxes.
Tempting? Sure. Dangerous? Absolutely. Uncle Sam prefers companies have W-2 employees, not only because the government can capture that tax revenue but because the payments come through regular withholding and, therefore, issues of unreported income are eliminated. Of course, federal rules and regulations are only part of the equation; many states, equally concerned about the so-called tax gap, add their own guidelines on top of those federal statutes.
What You Need To Know When Hiring a Freelancer
Unfortunately, the definition of employee versus independent contractor isn’t black-and-white–it depends on the nebulous phrase “evidence of degree of control and independence.” According to the IRS’s Common Law Rules, the three categories that they consider are as follows:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how a worker is paid, whether expenses are reimbursed and who provides tools/supplies.) Does the worker have profit/loss risk?
- Relationship of worker and firm: Are there written contracts or employee-type benefits (e.g., pension plan, insurance and vacation pay)? Will the relationship continue and is the work performed a key aspect of the business?
Within those broad categories, a few items indicate a freelancer is truly an independent contractor who should get a Form 1099 and who is not a W-2 staffer in disguise. Examples include, but are not limited to the following:
- Works with several different clients
- Has a home office or other dedicated office space
- Is incorporated
- Has a business bank account
- Has a business logo and/or website
- Performs work that could not be done by a full-time employee
- Has a relationship that can be terminated by either party without incurring liability or penalty
Need another reason to tighten up your independent contractor compliance? A disgruntled freelancer who believes they should be eligible for the benefits of a W-2 employee can force your hand by filing a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Subsequently, the IRS will ask you to complete a form SS-8 of your own–four pages of general information as well as details about behavioral and financial control and your relationship–to provide your version of the facts. Failure to respond won’t prevent the IRS from making a determination, and that determination could be deemed applicable to other workers of the same class within your business.
This is a complex topic with serious implications for your business. When hiring a freelancer, the more control and independence they have–in their financial position, responsibilities, hours and location of work, among other factors–the more confident you can feel about their independent contractor status. In cases where you require more control over work processes or even an in-office presence, you may want to inquire whether the freelancer is willing to perform the job as a part-time or temporary employee.
The prudent business owner or manager with any doubts should seek legal counsel. The risks of being wrong are higher than ever, particularly with increasing governmental scrutiny and changing regulations about how many weekly work hours qualify someone as a full- or part-time employee.
Disclaimer: The information provided here should not be considered to be a substitute for legal or tax advice. For legal assistance, contact a licensed attorney who is familiar with the federal and state requirements that apply to your particular business situation.
This post is adapted from Jake Poinier’s Dr. Freelance guide, Help! My Freelancers Are Driving Me Crazy: 12 Keys to Driving Loyalty and Results from Your Creative Workforce–available on Amazon.