Do You Use “Freelance Workers” In Your Biz? Watch Out!

It never ceases to amaze me how many small business owners are unclear on the rules regarding independent contractors. Just this past month, I discovered two of my new clients are paying “assistants” as independent contractors and another client was planning on hiring one! Sure, freelancers are great because they save you the cost and hassle of employees. You can add them as your business activity demands it and cut back when necessary. But if you are treating freelancers too much like employees, watch out for the IRS to penalize you for “worker misclassification.”

Just this past February, the IRS announced a new initiative targeting worker misclassification in small businesses. For the first three years, they’ve already randomly selected 6,000 businesses for audits! These National Research Program (NRP) audits will stretch across all industries and company sizes. The Treasury Department is anticipating additional employer tax revenues of $14 billion annually. President Obama is also anticipating additional revenues from this effort, as his 2011 budget proposal includes additional funding for 100 new Department of Labor employees to chase down cases of employee misclassification.

What happens if your “freelancer” is deemed to be a misclassified employee? The IRS will go after all of the employer taxes that you should have been paying, including Social Security, Medicare and Unemployment Insurance. These retroactive changes can go back several years and include significant penalties and interest. Once the IRS raises the red flag, the Department of Labor can jump in and assess minimum wage penalties and determine if you complied with overtime rules.

The audits are likely to focus on those industries most likely to engage in misclassification, including restaurants, construction, trucking, business services, child care services, landscaping and janitorial businesses. But if your business submits a large number of 1099 forms each year, you could well be on that audit list.

Are your freelancers really employees? The IRS has some standard guidelines on the subject on their Web site. The basic determining factor, though, is control:

• Do you tell your worker where, when and how to do their work?  Do you provide training for your worker? Do you require them to use your tools or computers?  These are all behavioral guidelines that identify a worker as an employee.  An independent contractor will generally supply their own tools and equipment, manage their own training, and do the work in the manner that they see fit.
• Do your contractors have an investment in their freelance business?  Do they advertise for other customers and make their services available to the public?  An independent contractor will have a profit motive in accepting work from you and will be able to make a profit — or lose money — on the job they perform.
• Do you have a contract with your contractor?  Do they work at your place of business or off-site?  If your worker is performing routine work in your business, at your business location, and expects an ongoing relationship, then you have an employee on your hands, not an independent contractor.

Are you unsure whether your worker is an employee or an independent contractor?  First visit the IRS web site and review their information; it really does explain the issue quite well. To help tip the balance towards an independent contractor classification, be sure your freelancer:

• Invoices you, instead of turning in a time card.
• Has other customers or is actively pursuing other customers.
• Has invested in their freelance business by buying business cards, advertising their business, buying liability insurance or paying for their own training.
• If possible, works off-site and is paid by the project rather than by the hour. You may not dictate work schedules, though requesting reports on project milestones are appropriate. The independent contractor is to determine how the work will be accomplished.
• Signs a written agreement. The agreement should include the tasks to be performed and the expected results, consistently identify the worker as an independent contractor, and specify the project’s duration without an automatic rollover.

If you realize that your worker best fits the “employee” description, then it is in your best interest to find a new freelancer who truly operates as an independent contractor or put your existing worker on payroll … pronto!