Today’s digital startups and small businesses are increasingly relying on a contract and freelance workforce. Whether in the cloud or locally, there’s a vast pool of experts—including designers, developers, social media pros and marketers ready to pitch in at a moment’s notice.
This growing workforce provides numerous unique benefits, including on-demand access to expertise, instant support for specific projects, more flexibility and, in some cases, less overhead and lower costs. Yet, while startups are reaping the benefits of keeping their employee count low, the government is on the lookout for employers who misclassify workers as independent contractors. According to a recent Wall Street Journal article, the IRS set a goal of investigating 6,000 employers over the past three years to make sure workers were properly classified.
For the federal and state governments, this increased crackdown is partly based on growing tax revenue. Employers don’t have to pay or withhold income taxes, Social Security, Medicare or unemployment taxes for independent workers like they do for employees. In addition, some employers might be turning to contractors to stay under the 50-employee threshold that will require them to pay for employee health insurance (or pay a penalty) under the federal health-care law slated to begin next year.
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However, even well-intentioned employers end up misclassifying workers. This is particularly true with young startups where speed is of the essence. If you’re hiring a contractor for your business, it’s critical to understand the legal nuances. If you’re caught making a mistake in classifying an employee as an independent contractor, you can be forced to pay hefty back taxes and penalties for federal and state income taxes, social security, medicare and unemployment. There can be other penalties and ramifications as well.
Employee Vs. Contractor
Unfortunately, there’s no single criterion that’s going to qualify someone as an independent contractor. In general, the classification comes down to how much control you (as an employer) have over the way work gets done. If you explicitly define when, where or how a job is to be done, then it’s probably not a contractor relationship.
The interesting thing is that this criteria holds true even for part-time or short-term help. You might think that if you hire someone for a limited time, that worker is automatically considered a contractor. After all, you’re not planning on hiring an employee for the long haul; you just need help for a project or two. However, whether someone is a contractor or employee comes down to the independence of the worker, and not necessarily for how long they’ll be working.
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For example, if you’re asking a software developer to work at your office from 9 to 5, then most likely that developer should be classified as a staff worker, not a contractor.
According to the Small Business Administration, an independent contractor and employee are defined as:
- Independent contractor: Operates under a business name, has his/her own employees and maintains a separate business checking account; advertises his/her business' services; invoices for work done; has more than one client; has own tools and sets own hours; keeps business records.
- Employee: Performs duties dictated or controlled by others; is given training for work to be done; works for only one employer.
Tips to Avoid Trouble
Just because the IRS may be cracking down on employers, you shouldn’t be scared away from properly taking advantage of independent talent. You just need to be savvy about the process. Here are a few tips.
1. Issue a Form 1099 for all independent contractors. This is a must, as every auditor will first ask to see your 1099s.
2. Don’t exert too much control or supervision over a contractor. You can set deadlines, but avoid setting specific hours for when they need to work. When possible, avoid giving your contractors such tight deadlines that they have to work full-time for you.
3. Don’t ask the contractor to work at your office or provide them with equipment unless it’s absolutely necessary.
4. Hire contractors who have incorporated their business, rather than ones who operate as sole proprietors. While this is one of the most effective ways to avoid auditing trouble, not every great contractor is going to be incorporated (so just be sure to follow the other tips).
5. Hire contractors who have different clients. If you are a freelancer’s only client for the year, that’s a red flag. If someone is just starting out and doesn’t have other clients yet, that’s okay. But verify that they are actively marketing or advertising their services.
6. Don’t give a contractor your employee handbook or ever refer to them as an employee of your business.
7. Make sure that all contractors issue invoices for their work. Never pay them biweekly, weekly or monthly like you would pay an employee.
By being smart and knowing the rules, you can use independent talent for your business. Talk to your tax professional or an attorney familiar with employment law if you have any questions about how to classify a worker.
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