As you may have heard, the Internal Revenue Service is cracking down on small businesses for underreporting their revenues. They're also on the watch for companies that misclassify freelancers -- an especially troublesome predicament for startups who routinely rely on contractors and freelancers, particularly in the early days.
In my view, the IRS is pushing enforcement because a tax gap occurs when a person doing work is determined to be a freelancer instead of a W2 employee. With a W2 employee, the government gets timely payments through withholding, there is no danger of non-reporting, the worker doesn’t write off expenses (home office, phone, etc.) and payment is made to unemployment insurance, workers comp and disability. Even though independent contractors are supposed to cover their own unemployment, workers comp and disability that still leaves a tax gap that is driving the IRS crackdown.
At Work Market, we work with companies of all sizes to manage contractors at scale. From clients like Lockheed Martin and Omnicom to companies just starting out, one of the biggest issues all businesses face is compliance. Our software is designed to monitor worker misclassification, and thus to provide our clients with tools to prevent potentially costly mistakes.
Here are four questions to ask to help you mitigate the risks involved with worker misclassification:
1. Is this person really a freelancer? Or does she run an independent business that performs a service for multiple companies? Did she incorporate? Does she have business insurance, a business bank account, an actual office? Does she have a website, a logo, marketing materials? For how many other customers does she provide services? These are the questions you need to answer in order to determine if the person is really a freelancer. If the answer to all these questions is no, you are better off making her a W2 employee. Once you know if the individual can be classified as freelancer then you can consider which type of control your business holds over the person, financial or behavioral.
Related: 5 Reasons the IRS's New Focus on Small Businesses Is Ridiculously Egregious
2. Do you have financial control over the person doing work? With a W2 employee this is not in question. The business pays a person a full-time salary for work performed. When working with freelancers, you should pay a fixed fee for projects and in turn they should have risk of profit or loss on the assignment. Avoid paying by time (hourly, daily or weekly), reimbursing expenses, or paying bonuses. Stay away from providing tools and/or equipment. Freelancers should have their own. The more the freelancer has financial control, the better.
3. How much influence can you have over this person's day? The less direction you give to the person the better. Employees are told what to do, but freelancers are told what needs to be done. Freelancers can also delegate responsibility to someone else to help get the assignment completed. You should avoid having freelancers working from your location or give them specific arrival and departure times. Freelancers should be able to work where and when they want.
4. How does this person's work get performed? In some ways, this is the most important test. The core of the IRS focus is determining whether the work should have, or could have, been done by a full-time employee. If you are engaging freelancers simply to not hire more full-time employees for something core to your business, you are taking on risk. You should not have employees sitting next to freelancers doing the same work.
An important thing to remember is that there are no hard and fast rules. The guidelines the IRS gives suggests employee patterns as well as freelancer patterns. In addition, the IRS doesn’t provide guidelines for the number of hours you can utilize freelancers.
The only hard lines appear within ERISA. If someone works with you for 1,500 hours and you have a retirement plan, ERISA guidelines may determine that you include them in your plan. Unfortunately, the regulations are still evolving: Under Obamacare, thirty hours a week for an extended period of time (yup, still not defined) is the emerging standard of working hours for a full-time employee.
So make sure your freelancers are really freelancers, pay them so they have profit/loss risk, don’t tell them what to do, when to do it or how to do it. And don’t engage freelancers who do what your full-time employees do.
What's the most confusing thing about classifying workers? Let us know with a comment.